Luxottica Group, S.p.A. 20-F 2006
Documents found in this filing:
Commission file number 1-10421
2, MILAN 20123, ITALY
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Item 17 o Item 18 x
Throughout this annual report, management has made certain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 which are considered prospective. These statements are made based on managements current expectations and beliefs and are identified by the use of forward-looking words and phrases such as plans, estimates, believes or belief, expects or other similar words or phrases.
Such statements involve risks, uncertainties and other factors that could cause actual results to differ materially from those which are anticipated. Such risks and uncertainties include, but are not limited to, fluctuations in exchange rates, economic and weather factors affecting consumer spending, the ability to successfully introduce and market new products, the availability of correction alternatives to prescription eyeglasses, the ability to successfully launch initiatives to increase sales and reduce costs, the ability to effectively integrate recently acquired businesses, including Cole National Corporation and its subsidiaries (Cole), risks that expected synergies from the acquisition of Cole will not be realized as planned and that the combination of Luxottica Groups managed vision care business with Cole will not be as successful as planned, as well as other political, economic and technological factors and other risks and uncertainties described in our filings with the Securities and Exchange Commission (the SEC). These forward-looking statements are made as of the date hereof, and we do not assume any obligation to update them.
Throughout this annual report, when we use the terms Luxottica, Company, we, us and our, unless otherwise indicated or the context otherwise requires, we are referring to Luxottica Group S.p.A. and its consolidated subsidiaries.
Our house brands and designer line prescription frames and sunglasses that are referred to in this annual report, and certain of our other products, are sold under names that are subject to registered trademarks held by us or, in certain instances, our licensors. These trademarks may not be used by any person without our prior written consent or the consent of our licensors, as applicable.
The following tables set forth selected consolidated financial data for the periods indicated and are qualified by reference to, and should be read in conjunction with, our consolidated financial statements, the related notes thereto, and Item 5Operating and Financial Review and Prospects contained elsewhere herein. We prepare our financial statements in accordance with accounting principles generally accepted in the United States of America, or U.S. GAAP. The selected consolidated financial information for and as of the years ended December 31, 2001, 2002, 2003, 2004 and 2005 is derived from our consolidated financial statements, which have been audited by Deloitte & Touche S.p.A., independent registered public accounting firm.
[TABLES APPEAR ON THE FOLLOWING PAGE]
(1) Translated for convenience at the rate of Euro 1.00 = U.S. $1.1842, based on the Noon Buying Rate of Euro to U.S. dollar on December 31, 2005. See Exchange Rate Information below for more information regarding the Noon Buying Rate.
(2) Earnings per Share for each year have been calculated based on the weighted-average number of shares outstanding during the respective years. Each American Depositary Share, or ADS, represents one ordinary share.
(3) Except per Share amounts, which are in Euro and U.S. dollars, as applicable.
(4) Cash Dividends Declared per Share are expressed in gross amounts without giving effect to applicable withholding or other deductions for taxes.
(5) Our dividend policy is based upon, among other things, our consolidated net income for each fiscal year, and dividends for a fiscal year are paid in the immediately following fiscal year. The dividends reported in the table were declared and paid in the fiscal year for which they have been reported.
(6) We acquired all of the outstanding shares of Sunglass Hut International, Inc. in April 2001. Therefore, 2001 includes approximately nine months of operating results of Sunglass Hut International, Inc. and its subsidiaries (Sunglass Hut).
(7) We acquired 82.57 percent of the outstanding shares of OPSM Group Limited (OPSM) in August 2003. As such, the results for 2003 include approximately five months of operating results of OPSM and its subsidiaries. In March 2005, we acquired the remaining 17.43 percent of the outstanding shares of OPSM and, from that date, 100 percent of the operating results of OPSM and its subsidiaries are included above.
(8) We acquired all of the outstanding shares of Cole in October 2004. Therefore, 2004 includes approximately three months of operating results of Cole.
(9) Certain amounts in prior years have been reclassified to conform with the 2005 presentation.
(1) Translated for convenience at the rate of Euro 1.00 = U.S. $1.1842, based on the Noon Buying Rate of Euro to U.S. dollar on December 31, 2005. See Exchange Rate Information below for more information regarding the Noon Buying Rate.
(2) Working capital is total current assets minus total current liabilities. See Item 5Operating and Financial Review and ProspectsLiquidity and Capital Resources.
We are required to pay an annual dividend on our ordinary shares if such dividend has been approved by a majority of our shareholders at the annual general meeting of shareholders. Before we may pay any dividends with respect to a fiscal year, we are required to set aside an amount equal to five percent of our statutory net income for such year in our legal reserve until the reserve, including any amounts set aside during prior years, is at least equal to one-fifth of the nominal value of our issued share capital.
At our annual general meeting of shareholders held on June 14, 2006, our shareholders approved the distribution of a cash dividend in the amount of Euro 0.29 per ordinary share. Our Board of Directors proposed, and the shareholders approved, the date of June 22, 2006 as the date for the payment of such dividend to all holders of record of our ordinary shares on June 16, 2006, including Deutsche Bank Trust Company Americas, as depositary on behalf of holders of our American Depositary Shares, or ADSs. Each ADS represents the right to receive one ordinary share and is evidenced by an American Depositary Receipt, or ADR. The ADSs were traded ex-dividend on June 19, 2006, and dividends in respect of the ordinary shares represented by ADSs were paid to Deutsche Bank Trust Company Americas on June 22, 2006. Deutsche Bank Trust Company Americas converted the Euro amount of such dividend payment into U.S. dollars on June 22, 2006. The dividend amount for each ADS holder will be paid commencing on June 29, 2006 to all such holders of record on June 21, 2006. Future determinations as to dividends will depend upon, among other things, our earnings, financial position and capital requirements, applicable legal restrictions and such other factors as the Board of Directors and our shareholders may determine.
The table below sets forth the cash dividends declared and paid on each ordinary share in each year indicated.
(1) Cash dividends per ordinary share are expressed in gross amounts without giving effect to applicable withholding or other deductions for taxes.
(2) Each ADS represents one ordinary share.
(3) Our dividend policy is based upon, among other things, our consolidated net income for each fiscal year, and dividends for a fiscal year are paid in the immediately following fiscal year. The dividends reported in the table were declared and paid in the fiscal year for which they have been reported.
(4) Translated at the Noon Buying Rate on the payment date to holders of ADSs. See Exchange Rate Information below for more information regarding the Noon Buying Rate.
(5) The dividend of Euro 0.29 per ordinary share was approved by our Board of Directors on April 27, 2006 and was voted upon and approved by our shareholders at the annual general meeting of shareholders held on June 14, 2006.
(6) The dividend per ordinary share was converted into U.S. dollars by Deutsche Bank Trust Company Americas on June 22, 2006.
Exchange Rate Information
The following tables set forth, for each of the periods indicated, certain information regarding the Noon Buying Rate in New York City for cable transfers in foreign currencies as certified for customs purposes by the Federal Reserve Bank of New York, which we refer to as the Noon Buying Rate, expressed in U.S. $ per Euro 1.00:
(1) The average of the Noon Buying Rates in effect on each business day during the period.
On June 23, 2006, the Noon Buying Rate was U.S. $1.2522 per Euro 1.00.
Unless otherwise indicated, all convenience translations included in this annual report of amounts expressed in Euro into U.S. dollars for the relevant period or date have been made using the Noon Buying Rate in effect as of the end of such period or date, as appropriate.
In this annual report, unless otherwise stated or the context otherwise requires, references to $, U.S. $, dollars or U.S. dollars are to United States dollars, references to Euro and are to the Common European Currency, the Euro, references to Rs are to Indian rupees, and references to AUD$ or A$ are to Australian dollars.
Our future operating results and financial condition may be affected by various factors, including those set forth below.
If we are unable to successfully introduce new products, our future sales and operating performance will suffer.
The mid- and premium-price categories of the prescription frame and sunglasses markets in which we compete are particularly vulnerable to changes in fashion trends and consumer preferences. Our historical success is attributable, in part, to our introduction of innovative eyewear products which are perceived to represent an improvement over products otherwise available in the market. Our future success will depend on our continued ability to develop and introduce such innovative products. If we are unable to continue to do so, our future sales could decline, inventory levels could rise, leading to additional costs for storage and potential writedowns relating to the value of excess inventory, and production costs would be negatively impacted since fixed costs would represent a larger portion of total production costs due to the decline in quantities produced.
If we fail to maintain an efficient distribution network in our highly competitive markets, our business, results of operations and financial condition could suffer.
The mid- and premium-price categories of the prescription frame and sunglasses markets in which we operate are highly competitive. We believe that, in addition to successfully introducing new products, responding to changes in the market environment and maintaining superior production capabilities, our ability to remain competitive is highly dependent on our success in maintaining an efficient distribution network. If we are unable to maintain an efficient distribution network, our sales may decline due to the inability to timely deliver products to customers and our profitability may decline due to an increase in our per unit distribution costs in the affected regions, which may have an adverse impact on our business, results of operations and financial condition.
If we do not correctly predict future economic conditions and changes in consumer preferences, our sales of premium products and profitability will suffer.
The fashion eyewear industry is cyclical. Downturns in general economic conditions or uncertainties regarding future economic prospects, which affect consumer disposable income, have historically adversely affected consumer spending habits in our principal markets and thus made the growth in sales and profitability of premium-priced product categories difficult during such downturns. Therefore, future economic downturns or uncertainties could have a material adverse effect on our business, results of operations and financial condition, including sales of our designer and other premium brands.
The eyewear industry is also subject to rapidly changing consumer preferences. There can be no assurance that the growth of the fashion eyewear industry will continue or that consumer preferences will not change in a manner which will adversely affect the fashion eyewear industry as a whole or us in particular. Changes in fashion could also affect the popularity and, therefore, the value of the fashion licenses granted to us by designers. Any event or circumstance resulting in reduced market acceptance of one or more of these designers could reduce our sales and the value of our inventory of models based on that design. Unanticipated shifts in consumer preferences may also result in excess inventory and underutilized manufacturing capacity. In addition, our success depends, in large part, on our ability to anticipate and react to changing fashion trends in a timely manner. Any sustained failure to identify and respond to such trends would adversely affect our business, results of operations and financial condition and may result in the write down of excess inventory and idle manufacturing facilities.
If we are unable to achieve and manage growth, operating margins will be reduced as a result of decreased efficiency of distribution.
In order to achieve and manage our growth effectively, we will be required to increase and streamline production and implement manufacturing efficiencies where possible, while maintaining strict quality control and the ability to deliver products to our customers in a timely and efficient manner. We must also continuously develop new product designs and features, expand our information systems and operations, and train and manage an increasing number of management level and other employees. If we are unable to manage these matters effectively, our efficient distribution process could be at risk and we could lose market share in affected regions.
If we do not continue to negotiate and maintain favorable license arrangements, our sales or cost of sales will suffer.
We have entered into license agreements that enable us to manufacture and distribute prescription frames and sunglasses under certain designer names, including Chanel, Prada, Dolce & Gabbana, D&G, Versace, Bulgari, Miu Miu, Salvatore Ferragamo, Donna Karan, DKNY, Genny, Byblos, Brooks Brothers, Sergio Tacchini, Anne Klein, Moschino, Versus and Adrienne Vittadini and, most recently, Burberry and Polo Ralph Lauren. These license agreements typically have terms of between three and ten years (except for the license agreement for the Moschino line, which is terminable upon 12 months notice), may contain options for renewal for additional periods and require us to make guaranteed and contingent royalty payments to the licensor. See Item 4Information on the CompanyBusiness OverviewRecent Developments regarding our new license agreements for the Burberry and Polo Ralph Lauren names. We believe that our ability to maintain and negotiate favorable license agreements with leading designers in the fashion and luxury goods industries is essential to the branding of our products and, therefore, material to the success of our business. Accordingly, if we are unable to negotiate and maintain satisfactory license arrangements with leading designers, our growth prospects and financial results could suffer from a reduction in sales or an increase in advertising costs and royalty payments to designers.
If vision correction alternatives to prescription eyeglasses become more widely available, or consumer preferences for such alternatives increase, our business could be adversely affected.
Our business could be negatively impacted by the availability and acceptance of vision correction alternatives to prescription eyeglasses, such as contact lenses and refractive optical surgery. According to industry estimates, over 40 million people wear contact lenses in the United States, and disposable contact lenses is the fastest growing segment of the lens subsector. In addition, the use of refractive optical surgery has grown substantially since it was approved by the U.S. Food and Drug Administration in 1995.
Increased use of vision correction alternatives could result in decreased use of our prescription eyewear products, including a reduction of sales of lenses and accessories sold in our retail outlets, which would have a material adverse impact on our business, results of operations, financial condition and prospects.
If the Euro continues to strengthen relative to certain other currencies, our profitability as a consolidated group will suffer.
Our principal manufacturing facilities are located in Italy, and we maintain sales and distribution facilities throughout the world. As a result, we are vulnerable to foreign exchange rate fluctuations in two principal areas:
we incur most of our manufacturing costs in Euro and receive a significant part of our revenues in other currencies, particularly the U.S. and Australian dollars. Therefore, a strengthening of the Euro relative to other currencies in which we receive revenues could negatively impact the demand for our products or decrease our profitability in consolidation, thus adversely affecting our business and results of operations; and
a substantial portion of our assets, liabilities, revenues and costs are denominated in various currencies other than Euro, with most of our operating expenses in U.S. dollars. As a result, our operating results, which are reported in Euro, are affected by currency exchange rate fluctuations, particularly between the U.S. dollar and the Euro.
As our international operations grow, future changes in the exchange rate of the Euro against the U.S. dollar and other currencies may negatively impact our reported results.
See Item 11Quantitative and Qualitative Disclosures about Market Risk.
If our international sales suffer due to changing local conditions, our profitability and future growth will be affected.
We currently operate worldwide and intend to expand our operations in many countries, including certain developing countries in Asia. Therefore, we are subject to various risks inherent in conducting business internationally, including the following:
exposure to local economic and political conditions;
export and import restrictions;
currency exchange rate fluctuations and currency controls;
withholding and other taxes on remittances and other payments by subsidiaries;
investment restrictions or requirements; and
local content laws requiring that certain products contain a specified minimum percentage of domestically produced components.
The likelihood of such occurrences and their potential effect on us vary from country to country and are unpredictable, but any such occurrence may result in the loss of sales or increased costs of doing business and may have a significant effect on our business, results of operations, financial condition and prospects.
If we are unable to protect our proprietary rights, the loss of sales and the costs of defending such rights will adversely affect our business and financial results.
We rely on trade secret, unfair competition, trade dress, trademark, patent and copyright laws to protect our rights to certain aspects of our products, including product designs, proprietary manufacturing processes and technologies, product research and concepts and recognized trademarks, all of which we believe are important to the success of our products and our competitive position. However, pending trademark applications may not generate registered trademarks, and any trademark registration that is granted may be ineffective in preventing competition and could be held invalid if subsequently challenged. In addition, the actions we take to protect our proprietary rights may be inadequate to prevent imitation of our products. Our proprietary information could become known to competitors, and we may not be able to meaningfully protect our rights to proprietary information. Furthermore, other companies may independently develop substantially equivalent or better products that do not infringe on our intellectual property rights or could assert rights in, and ownership of, our proprietary rights. Moreover, the laws of certain countries do not protect proprietary rights to the same extent as the laws of the United States.
We devote significant resources toward defending our proprietary rights. However, if the level of potentially infringing activities by others were to increase substantially, we might have to significantly increase the resources we devote to protecting our rights. Additionally, an adverse determination in any dispute involving our proprietary rights could, among other things, (i) require us to grant licenses to, or obtain licenses from, third parties, (ii) prevent us from manufacturing or selling our products or (iii) subject us to substantial liability. Any of these possibilities could have a material adverse effect on our business, results of operations, financial condition and prospects.
If we are unable to maintain our current operating relationship with Cole Licensed Brands host stores, we would suffer loss of sales and possible impairment of certain intangible assets.
Our sales depend in part on our relationships with the host stores that sell Coles Licensed Brands products, including Sears. Our leases and licenses with Sears are terminable upon short notice. If our relationship with Sears were to end, we would suffer a loss of sales and the possible impairment of certain intangible assets. This could have a material adverse effect on our business, results of operations, financial condition and prospects.
If we become subject to adverse judgments or determinations in legal proceedings to which we are, or may become, a party, then our business could be adversely affected.
We are currently a party to certain legal proceedings as described in Item 8Financial InformationLegal Proceedings. In addition, in the ordinary course of our business, we become involved in various other claims, lawsuits, investigations and governmental and administrative proceedings, some of which are significant. Adverse judgments or determinations in one or more of these proceedings could require us to change the way we do business or use substantial resources in adhering to the settlements and could have a material adverse effect on our business, results of operations and financial condition.
If we become subject to additional regulation by governmental authorities, our compliance with these regulations could have an adverse effect on our business, results of operations and financial condition.
Our operations are subject to regulation by governmental authorities in the United States and other jurisdictions in which we conduct business. Governmental regulations, both in the United States and other jurisdictions, have historically been subject to change. New or revised requirements imposed by governmental regulatory authorities could have an adverse effect on us, including increased costs of compliance. We may also be adversely affected by changes in the interpretation or enforcement of existing laws and regulations by governmental authorities that could affect sales or the way we currently distribute our products.
See Item 4Information on the CompanyRegulatory Matters and Item 8Financial InformationLegal Proceedings.
If we are not successful in completing and integrating strategic acquisitions to expand or complement our business, our future profitability and growth will be at risk.
As part of our growth strategy, we have made, and may continue to make, strategic business acquisitions to expand or complement our business. Our acquisition activities, however, can be disrupted by overtures from competitors for the targeted candidates, governmental regulation and rapid developments in our industry. We may face additional risks and uncertainties following an acquisition, including: (i) difficulty in integrating the newly-acquired business and operations in an efficient and effective manner; (ii) inability to achieve strategic objectives, cost savings and other benefits from the acquisition; (iii) the lack of success by the acquired business in its markets; (iv) the loss of key employees of the acquired business; (v) the diversion of the attention of senior management from our operations; and (vi) liabilities that were not known at the time of acquisition or the need to address tax or accounting issues. Specifically, with regard to our acquisition of Cole, we may face additional risks and uncertainties following such acquisition, including: (i) difficulty in integrating the newly acquired business and operations in an efficient and effective manner; (ii) inability to achieve strategic objectives, cost savings and other benefits from the acquisition; (iii) the lack of success by the acquired business in its markets; (iv) the loss of key employees of the acquired business; (v) the diversion of the attention of senior management from our operations; (vi) liabilities that were not known at the time of acquisition or creation of tax or accounting issues; (vii) difficulty in the consolidation of Coles headquarters with Luxottica Retail headquarters in Mason, Ohio; (viii) difficulty integrating Coles human resources systems, operating systems, inventory management systems, and assorted planning systems with the Companys systems; (ix) difficulty integrating Coles distribution center with the Companys distribution center; (x) difficulty finalizing the integration of product assortment; (xi) difficulty integrating Coles Managed Vision Care system with the Companys Managed Vision Care system; (xii) the inability of the Company to minimize the disruptive effect of the integration on the management of the Companys retail business; (xiii) difficulty in the timely creation and effective implementation of uniform standards, controls, procedures and policies; and (xiv) the cultural differences between the Companys organization and Coles organization. If we fail to timely recognize or address these matters or to devote adequate resources to them, we may fail to achieve our growth strategy or otherwise not realize the intended benefits of any acquisition.
We operate in two industry segments: (i) manufacturing and wholesale distribution and (ii) retail distribution. Through our manufacturing and wholesale distribution segment, we are engaged in the design, manufacture, wholesale distribution and marketing of house and designer lines of mid- to premium-priced prescription frames and sunglasses. Based on sales, we are the world leader in the design, manufacture and distribution of prescription frames and sunglasses in the mid- and premium-price categories.
With respect to our manufacturing activities, we operate six production facilities in Italy. A seventh facility was closed during 2004 and such closure did not have a material effect on our 2004 statement of operations. In addition, we operate a manufacturing facility in China. In 2005, we manufactured approximately 33.9 million prescription frames and sunglasses.
Our products are marketed under a variety of well-known brand names. Our house brands include Ray-Ban, Revo, Arnette, Killer Loop, Persol, Vogue, Luxottica and Sferoflex. Our designer lines include Chanel, Prada, Dolce & Gabbana, D&G, Versace, Bulgari, Miu Miu, Salvatore Ferragamo, Donna Karan, DKNY, Genny, Byblos, Brooks Brothers, Sergio Tacchini, Anne Klein, Moschino, Versus and Adrienne Vittadini . Commencing in October 2006, our designer lines will include Burberry, and commencing on January 1, 2007, they will include Polo Ralph Lauren.
With respect to our distribution activities, we operate our business through an extensive worldwide wholesale and retail distribution network based primarily in North America and Australia. In 2005, through our wholesale and retail networks, we distributed approximately 17.3 million prescription frames and approximately 21.8 million sunglasses in approximately 4,125 models. Our products are distributed in approximately 120 countries worldwide.
Our wholesale network is comprised of 29 wholly- or partially-owned subsidiaries operating in principal markets, over 1,300 sales representatives and approximately 100 independent distributors. Our primary wholesale customers include retailers of mid- and premium-priced eyewear such as independent opticians, optical and sunglass chains, optical superstores, sunglass specialty stores and duty-free shops. In certain countries, and especially in North America, wholesale customers also include optometrists and ophthalmologists, health maintenance organizations, or HMOs, and department stores.
Our retail network is mainly comprised of our subsidiaries: in North America, LensCrafters, Inc. (LensCrafters), Sunglass Hut and Cole, which operates Pearle and our Licensed Brands; and in Australia, New Zealand and Asia, OPSM, of which we acquired majority control in August 2003 and full control in March 2005. Luxotticas North American retail business is the largest optical retail business in North America based on total sales. Our retail network in Asia has expanded in 2006 with two acquisitions. In April 2006, we completed our acquisition of Beijing Xueliang Optical Technology Co. Ltd., a 79-store chain located in Beijing, China and, in July 2006, we expect to complete our acquisition of Ming Long Optical, a 133-store chain and the largest premium optical chain in the province of Guangdong, China.
See Products and Services below for a more detailed discussion of our business.
In 1961, Leonardo Del Vecchio and others established our original operations in Agordo, near Belluno, in northeastern Italy. Since that time, we have enjoyed significant growth in the scope and size of our operations. We have developed and grown in several phases, each of which is related to a specific business strategy. Throughout most of the 1960s, we manufactured molds, metal-cutting machinery, frame parts and semi-finished products for the optical market. We then progressively expanded our production capabilities to enable us to produce a finished frame product.
In 1969, we launched our first line of Luxottica brand frames and began our transformation from a third-party supplier to an independent manufacturer with a line of branded products.
In the early 1970s, we distributed our products exclusively through wholesalers. In 1974, with the acquisition of the distributor that had marketed the Luxottica product line in Italy since 1971, we took our first step towards vertical integration.
Luxottica Group S.p.A. was organized as a corporation on November 23, 1981 under the laws of the Republic of Italy. During the early 1980s, we continued to pursue vertical integration by acquiring independent optical distributors and forming wholesale subsidiaries in strategic markets. In 1981, with our acquisition of La Meccanoptica Leonardo S.p.A., the owner of the Sferoflex brand and the holder of an important patent for a flexible hinge, we increased our market share in Italy and various key European markets. During the late 1980s, we began to expand our product lines to include the design, manufacture and distribution of designer frames through license agreements with major fashion designers.
In 1990, our ADSs were listed on the New York Stock Exchange. Throughout the 1990s, we continued to expand our distribution network by forming new wholesale subsidiaries. In 1995, we became the first frame manufacturer to enter the North American retail market through the acquisition of LensCrafters. Throughout the 1990s, we also expanded into the sunglasses business through various acquisitions. In 1990, we acquired Florence Line S.p.A., the owner of the Vogue brand. In 1995, we acquired the medium- to high-end brand product line of Persol S.p.A.
In June 1999, we acquired the Global Eyewear Division of Bausch & Lomb Incorporated, which we refer to as our Ray-Ban business. The Ray-Ban acquisition significantly increased our presence in the sunglasses market, strengthened our house brand portfolio and provided us with sunglass crystal lens manufacturing technology, manufacturing facilities and equipment.
In December 2000, our ordinary shares were listed on the Mercato Telematico Azionario della Borsa Italiana S.p.A., which we refer to as the Italian Stock Exchange.
In April 2001, we continued to strengthen our sunglasses business by acquiring Sunglass Hut, a leading retailer of sunglasses worldwide based on sales. In May 2001, we acquired all of the issued and outstanding common stock of First American Health Concepts, Inc., which at that time was a leading provider of managed vision care plans in the United States based on sales. In August 2003, we acquired 82.57 percent of the outstanding shares of OPSM (we acquired the remaining 17.43 percent interest in March 2005), resulting in our leadership position in the prescription business based on sales in the Australian and New Zealand markets, while at the same time presenting us with new growth opportunities in the Asia-Pacific markets. In October 2004, we strengthened and expanded our North American retail and managed vision care business with the acquisition of Cole. In 2005, we expanded our retail presence in China by entering into agreements to buy two premium retail chains, Beijing Xueliang Optical Technology Co. Ltd. and Ming Long Optical, to become a leading operator of premium optical stores in China based on the number of stores, with a total of 278 locations in two of the top premium optical markets in Mainland China, as well as Hong Kong, an important market in Asia for luxury goods. We are awaiting customary approvals by the relevant Chinese governmental authorities regarding the agreement to acquire Ming Long Optical and anticipate receiving such approvals by July 2006.
Our principal executive offices are located at Via Cantù 2, Milan, 20123, Italy, and our telephone number at that address is (011) 39-02-863341. Our agent for service for limited purposes in the United States is CT Corporation, 111 Eighth Avenue, New York, New York 10011, telephone number (212) 894-8940. We are domiciled in Milan, Italy.
On October 7, 2005, we announced the signing of a 10-year license agreement for the design, production and worldwide distribution of prescription frames and sunglasses under the Burberry name. The first Burberry eyewear collections under the agreement will be presented in October 2006.
On February 27, 2006, we announced the signing of a 10-year license agreement for the design, production and worldwide distribution of prescription frames and sunglasses under the Polo Ralph Lauren name. Performance under the agreement will commence on January 1, 2007.
On July 7, 2005, we announced that our subsidiary, SPV Zeta S.r.l., had entered into an agreement to acquire 100 percent of the equity interest in Beijing Xueliang Optical Technology Co. Ltd. for a purchase price of Chinese Renminbi (RMB) 169 million (approximately Euro 17 million), plus RMB 40 million (approximately Euro 4 million) in assumed liabilities. Xueliang Optical had unaudited sales for the 2004 fiscal year of RMB 102 million (approximately Euro 10 million). Xueliang Optical has 79 stores in Beijing. The Company completed the acquisition in April 2006.
On October 4, 2005, we announced that our subsidiary, SPV Eta S.r.l., had entered into an agreement to acquire 100 percent of the equity interests in Ming Long Optical, the largest premium optical chain, based on number of stores, in the province of Guangdong, China, with 133 stores, for a purchase price of RMB 290 million (approximately Euro 29 million). As a result, we will become the leading operator of premium optical stores in China based on the number of stores, with a total of 278 locations in two of the top premium optical markets in Mainland China, as well as in Hong Kong, the most important market in Asia for luxury goods. Completion of the transaction remains subject to customary approvals by the relevant Chinese governmental authorities. The Company currently anticipates receiving such approvals by July 2006.
On May 18, 2006, we announced that we had entered into agreement to acquire Shoppers Optical, a 74-store Canadian-based optical chain owned by King Optical Group Inc. Once the transaction is completed, we will manage a total of 268 optical stores in Canada. Shoppers Optical operates across eight of Canadas provinces. Twenty-six of Shoppers Opticals stores are in the province of Ontario, where nearly 40 percent of the Canadian population lives. In addition, this acquisition will bring into the organization the first full-service Canada-based central lens finishing lab with anti-reflective coating capability. The closing of the transaction, which is subject to customary closing conditions, is expected to take place at the end of June 2006.
In June 2006, we announced that we plan to acquire 100 percent of the equity interest in Modern Sight Optics, a leading premium optical chain that operates a total of 28 stores in Shanghai, China, for total consideration of RMB 140 million (approximately Euro 14 million). Completion of the transaction is subject to customary approvals by the relevant Chinese governmental authorities. We expect to receive such approvals by the end of 2006.
Retail Expansion through Franchising
In June 2006, we announced a five-year franchising agreement with Azal Group that will expand our Sunglass Hut chain by up to 50 stores in the Middle East by 2008. Azal Group has operations in the Middle East and Europe and has a franchise portfolio of over 30 brands, including some of the industrys most recognizable brands.
On August 31, 2005, we agreed with the plaintiffs in the previously disclosed action commenced in May 2001 (the Action) pending in the U.S. District Court for the Eastern District of New York relating to its acquisition of Sunglass Hut to a full and final settlement and release (the Settlement) of all claims made in the Action. In the Action, the plaintiffs principal claim was that certain payments made to the former Chairman of SGHI under a consulting, non-disclosure and non-competition agreement violated the best price rule under U.S. securities laws. The Settlement was approved by the Court, and final judgment has been entered dismissing the case with prejudice.
California Vision Health Care Service Plan Lawsuit
In March 2002, an individual commenced an action in the California Superior Court for the County of San Francisco against Luxottica Group S.p.A. and certain of our subsidiaries, including LensCrafters, Inc. and EYEXAM of California, Inc. The plaintiff, along with a second plaintiff named in an amended complaint, seeks to certify this case as a class action. The claims have been partially dismissed. The remaining claims, against LensCrafters, EYEXAM and EyeMed Vision Care, LLC, allege various statutory violations relating to the confidentiality of medical information, the operation of LensCrafters stores in California, including violations of California laws governing relationships among opticians, optical retailers, manufacturers of frames and lenses and optometrists, false advertising and other unlawful or unfair business practices. The action seeks unspecified damages, disgorgement and restitution of allegedly unjustly obtained sums, statutory damages, punitive damages and injunctive relief, including an injunction that would prohibit defendants from providing eye examinations or other optometric services at LensCrafters stores in California. In May 2004, the trial court stayed all proceedings in the case pending the California Supreme Courts decision in a case against Cole and its subsidiaries expected to address certain legal questions related to the issues presented in this case. On June 12, 2006, the California Supreme Court rendered its decision in that case, ruling that optical stores such as those operated by Cole must comply with Sections 655 and 2556 of the California Business and Professions Code. It is expected that plaintiffs will now seek to resume their prosecution of this action. Although we believe that our operational practices in California comply with California law, an adverse decision in this action or the suit against Cole might cause LensCrafters, EYEXAM and EyeMed to modify or close certain activities in California. Further, LensCrafters, EYEXAM and EyeMed might be required to pay damages and/or restitution, the amount of which might have a material adverse effect on our operating results, financial condition and cash flow.
People v. Cole
In February 2002, the State of California commenced an action in the California Superior Court for the County of San Diego against Cole and certain of its subsidiaries, including Pearle Vision, Inc. and Pearle Vision Care, Inc. The claims allege various statutory violations related to the operation of Pearle Vision Centers in California including violations of California laws governing relationships among opticians, optical retailers, manufacturers of frames and lenses and optometrists, false advertising and other unlawful or unfair business practices. The action seeks disgorgement and restitution of allegedly unjustly obtained sums, civil penalties and injunctive relief, including an injunction that would prohibit defendants from providing eye examinations or other optometric services at Pearle Vision Centers in California. In July 2002, the trial court entered a preliminary injunction to enjoin defendants from certain business and advertising practices. Both Cole and the State of California appealed that decision. On November 26, 2003, the Court of Appeal issued an opinion in which it stated that because California law prohibited Pearle Vision from providing eye examinations and other optometric services at Pearle Vision Centers, the trial court should have enjoined Pearle Vision from advertising the availability of eye examinations at Pearle Vision Centers. The appellate court also ruled in Coles favor with respect to charging dilation fees, which ruling partially lifted the preliminary injunction with respect to these fees that had been imposed in July 2002. On March 3, 2004, the California Supreme Court granted Coles petition for review of the portion of the appellate courts decision stating that California law prohibited defendants from providing eye examinations and other optometric services at Pearle Vision Centers. The appellate courts decision directing the trial court to enjoin Pearle Vision from advertising these activities was stayed pending the Supreme Courts resolution of the issue. On June 12, 2006, the California Supreme Court affirmed the Court of Appeals prior decision, and held that optical stores such as those operated by Cole must comply with Sections 655 and 2556 of the California Business and Professions Code. The matter will now be remanded to the trial court for further proceedings to determine if, in fact, Coles operations comply with those laws. In addition, the preliminary injunction previously issued to enjoin advertising of the availability of eye examinations at Pearle Vision Centers, may soon become operative. Although we believe that Coles operational practices in California comply with California law, an adverse decision in this action may compel Cole and its subsidiaries to modify or close certain activities in California. Further, Cole and its subsidiaries might be required to pay civil penalties and/or restitution, the amount of which might have a material adverse effect on our operating results, financial condition and cash flow.
Cole SEC Investigation
Following Coles announcement in November 2002 of the restatement of its financial statements, the SEC began an investigation into Coles previous accounting. The SEC subpoenaed various documents from Cole and deposed numerous former officers, directors and employees of Cole. During the course of this investigation the SEC staff had indicated that it intended to recommend that a civil enforcement action be commenced against certain officers and directors of Cole but not against Cole. Cole was obligated to advance reasonable attorneys fees incurred by current and former officers and directors who were involved in the SEC investigation subject to undertakings provided by such individuals. Cole has insurance available with respect to a portion of these indemnification obligations. In March 2006, the SEC staff indicated that it had concluded its investigation and that, contrary to its earlier indication, it would not be recommending that an enforcement action be commenced against anyone in connection with the investigation.
Amended Credit Agreement
On March 10, 2006, we and our subsidiary Luxottica U.S. Holdings Corp. (U.S. Holdings) and the bank group parties to their three-Tranche credit agreement signed on June 3, 2004, agreed to amend the outstanding credit agreement. The amended agreement reduces the interest margin as defined in the agreement, extends the termination date of Tranches B and C to five years from the date the amendment was signed, gives the option at the end of the first and second anniversaries to extend the termination for additional one-year periods and increases the borrowing capacity of Tranche C to Euro 725.0 million from Euro 335.0 million.
Products and Services
In our wholesale operations, we manufacture and sell our prescription frames and sunglasses as either house brands or designer lines. House brands consist of eyewear sold under brand names that we own. Designer lines are produced under designer names held by us under license agreements with third parties. Our products, for both house brands and designer lines, consist of a variety of different styles, from conventional to contemporary and fashion forward styling. Each brand is tailored for a specific market segment based on certain characteristics, such as the consumers age, lifestyle and fashion consciousness.
House Brands: Our house brands, almost entirely designed and manufactured by us, are sold worldwide under brand names such as Luxottica, Sferoflex, Vogue, Persol, Ray-Ban, Revo, Killer Loop and Arnette. We currently produce approximately 1,600 distinct styles of frames within our house brands. Each style is typically produced in three sizes and at least four colors. Actual availability of product styles, colors and sizes varies among geographic markets depending upon local demand.
The following is a summary description of each of our most significant house brands:
Persol: Created in 1917 and acquired by Luxottica in 1995, the Persol brand is synonymous with design, elegance, tradition, and technical precision. Our Persol line, which includes a wide range of prescription frames and sunglasses, is marketed as a timeless fashion accessory due to the elegance and design of our products.
Arnette: Targeted to young consumers, this sports product line is characterized by a very forward-thinking design.
Luxottica: Luxottica is our first product line, comprised of prescription frames and sunglasses. Luxottica targets a broad mix of consumers of eyewear.
Sferoflex: This product line, which in 1981 became the first brand name acquired by Luxottica Group, the Sferoflex line is comprised of prescription frames characterized by a classic and comfortable style, with flexible hinges that allow the frame to adapt to the unique face shape of each wearer.
Killer Loop: Created in 1989 as a sun and sports eyewear brand that combines design and quality, this brand has evolved throughout the years from exclusively sports eyewear to also include leisure eyewear.
Designer Lines: Our designer lines are produced and distributed through license agreements with major fashion houses. Currently, we produce 18 designer lines under the names Chanel, Prada, Dolce & Gabbana, D&G, Versace, Bulgari, Miu Miu, Salvatore Ferragamo, Donna Karan, DKNY, Genny, Byblos, Brooks Brothers, Sergio Tacchini, Anne Klein, Moschino, Versus and Adrienne Vittadini. Commencing in October 2006, our designer lines will include Burberry, and commencing on January 1, 2007, they will include Polo Ralph Lauren. The license agreements governing these designer lines are exclusive contracts and typically have terms of between three and ten years (except the license agreement for the Moschino line, which is terminable upon 12 months notice). See Trademarks, Trade Names and License AgreementsLicense Agreements. Designer collections are developed through the collaborative efforts of our in-house design staff and the brand designer. Our designer lines presently feature approximately 2,500 different styles.
The following is a summary description of our main designer lines:
Chanel: In 1999, we became the first company licensed to produce Chanel products. The Chanel product line, targeting the high-end consumer, reflects the essential characteristics of the brand: style, elegance and class.
Prada: The Prada license agreement was signed in 2003. The Prada collections offer a range of glasses proposed in optical frames and sunglasses collections, and also a series of models created for leisure time, identified by the unmistakable red stripe. The Prada collections have always been distinctive not only for their high quality but also for their forward-thinking approach and style, enabling the brand to anticipate and often inspire trends across all sectors. Sophisticated, elegant and refined, Prada products are identified by their strong character and unique style.
Miu Miu: The Miu Miu license agreement was signed in 2003 and it comprises both optical frames and sunglasses. This brand addresses a clientele particularly attentive to the free and easy as well as to the sophisticated new trends. This collection expresses Miuccia Pradas vision of an alternative style, always characterized by a strong personality. The brand Miu Miu can be defined as: urban, young, sophisticated and sensual, an alternative vision, a new classic.
Versace: Versace is a lifestyle brand for the modern man or woman who chooses to express his/her strength, confidence and uniqueness through a bold and distinctive personal style. Versace represents the ideal of a sophisticated, free and highly desirable lifestyle.
Versus: While staying true to the essence of the core brand, Versus represents a younger, edgier take on those themes. Filled with spirit and energy, Versus challenges convention, always in the vanguard of modern urban style.
Bulgari: Bulgari eyewear is distinguished by the high quality of its material, attention to detail and elegant design. This product line is targeted towards a clientele who seek something exclusive.
Salvatore Ferragamo: The first Salvatore Ferragamo eyewear line debuted in late 1998, the year we executed the Salvatore Ferragamo license agreement. The Salvatore Ferragamo collections include both optical frames and sunglasses; they are characterized by the greatest attention to detail as well as by an original use of materials and choice of colors. The eyewear collection is inspiredlike all the other Salvatore Ferragamo productsby the craftsmanlike tradition of this fashion house, reinterpreted according to contemporary trends.
Moschino: Original and different, with a combination of shapes, materials and colors which become provocative, amusing, innovative and at times surprisingly fascinating and seductive.
Byblos: Byblos presents an elegant, dynamic collection that is lively and concrete in its essentialism but which at the same time knows how to be sporty without being excessive or aggressive. The distinctive trait of the Byblos collections is the winning combination of sport and fashion, with an eye on trends to keep its designs always up to date.
Genny: The first Genny branded womens eyewear line was manufactured and distributed in 1989. Targeted at the premium-price market segment, Genny eyewear is designed for a classic and sophisticated woman who is feminine, self-assured, aware of fashion trends and who wants a distinctive yet not excessive style.
Brooks Brothers: . Characterized by lightweight materials and a slender line, the Brooks Brothers collections reflect the unique features of the style of this American brand. This is an affordable product line with classic style that delivers functionality, lightness and high quality.
Anne Klein: This product line targets successful professional women who place an emphasis on quality and image.
Donna Karan: This product line reflects the design sensibility and spirit of the Donna Karan Collection, offering men and women styles that are sophisticated, using modern and lightweight materials.
DKNY: DKNY is fast fashion with an urban mind-set, the New York City street-smart look. DKNY Eyewear addresses modern, urban, fashion-conscious women and men with multifaceted lifestyles: international, eclectic, fun and real.
Dolce & Gabbana: Our first Dolce & Gabbana eyewear collection draws its inspiration from the 60s and 70s. This collection brings the periods shapes up to date and highlights its materials, characterized by precious details such as logos in Swarovski crystals or elegant metal circles.
D&G: The D&G eyewear collection has a youthful, innovative and anti-conventional spirit. The new D&G models manufactured by Luxottica are characterized by vintage forms that take their inspiration from the 70s and 80s, as well as loud and colorful sporty frames reminiscent of the racing world.
Burberry: A license agreement between Burberry Group Plc and Luxottica was signed in October 2005 for the first release of the Burberry Eyewear Collection in October 2006. This collection will feature the brands core values of form and function, innovation and the essence of classic style.
Polo Ralph Lauren: During the first quarter of 2006, a ten-year license agreement was negotiated and signed with Polo Ralph Lauren Corp. for the manufacturing and distributing the Polo Ralph Lauren brands. The first eyewear collection will be presented in the fourth quarter of 2006 for sales beginning in January 2007.
The following table presents the respective percentages of our total unit (a unit represents an eyeglass frame or sunglass and excludes sales of other materials) sales that our designer and house brands comprised during the periods indicated:
Prescription Frames and Sunglasses
In 2005, we produced a combined total of approximately 33.9 million prescription frames and sunglasses. In 2004 and 2003, we produced a combined total of approximately 30.5 million and 28.7 million prescription frames and sunglasses, respectively.
Since 1990, sunglasses have become an increasingly significant product line for us as we seek to capitalize on growth opportunities in the sunglasses segment. In 1990, we acquired a distributor that supplied sunglasses under the Vogue brand name. In 1995, we expanded our activities in the sunglasses market by acquiring Persol S.p.A., an Italian producer of high-quality, fashionable sunglasses and prescription frames in the premium-priced segment of the market. In 1999, we acquired the Ray-Ban business from Bausch & Lomb Incorporated, including the Ray-Ban, Revo, Arnette and Killer Loop brand names. As a result of our acquisition of the Ray-Ban business, the percentage of our unit sales represented by sunglasses that we manufacture has grown significantly. This trend continued with the acquisition of Sunglass Hut. However, with the acqusitions of OPSM and Cole, which tend to focus on sales of opthalmic products and accessories, we have seen a steady decrease in our percentage units of sunglass sales to total unit sales over the last few years. We believe that this percentage of sales of sunglass units will continue to slightly decline in 2006 and 2007 due to our acquisitions in China and
Canada before stabilizing in the low to mid 50 percent range. Unit sales of sunglasses manufactured by us and third parties in 2005, as a percentage of total unit sales, were 55.8 percent, as compared to 58.9 percent in 2003 and 57.3 percent in 2004.
The following table presents the respective percentages of our total unit sales that our prescription frames and sunglasses comprised for the periods indicated:
Our Retail Division is operated by our subsidiaries LensCrafters, Sunglass Hut, OPSM and the Cole group of companies. LensCrafters and Sunglass Hut are strong trade names in the North American retail market place, and OPSM owns three main trade names in the Asia-Pacific market. The Cole National group of companies operates Pearle and our Licensed BrandsSears Optical, Target Optical and BJs Optical. In addition to ophthalmic products and sunglasses, we also sell watches and accessories under the store names Watch World and Watch Station and personalized gifts under the store name Things Remembered.
LensCrafters. Through LensCrafters, we operate a retail network of over 893 locations which offer a wide selection of prescription frames, sunglasses, lenses and other optical products in the North American market. LensCrafters is currently the largest optical retail chain in North America in terms of sales. LensCrafters stores sell not only Luxottica products, but also a wide range of lenses and optical products made by other suppliers. LensCrafters products include innovative lenses, such as FeatherWatesÔ (lightweight, thin and impact-resistant lenses), FeatherWates Complete with ScotchgardÔ (thin, light, scratch and impact resistant, anti-reflective and easy-to-clean lenses), DURALENSÔ (super scratch-resistant lenses), ByeLinesÔ (bifocal lenses without visible lines), InvisiblesÔ (anti-reflective lenses) and MVP Maximum View Progressives (multi-focal lenses without visible lines). Substantially all of our LensCrafters stores are located in high-traffic commercial malls and shopping centers, have an employed optometrist or an independent, licensed optometrist on site (thereby allowing the customer to have an eye examination on site), provide a large range of prescription eyewear choices and include a laboratory, which enables us to provide the selected frame with prescription lenses to our customers in approximately one hour.
We believe that our acquisition of LensCrafters in 1995 has allowed us to:
obtain a significant competitive advantage for market share in the North American market; and
enter a complementary segment that allows for a direct distribution to, and closer relationship with, the end customer.
When we acquired LensCrafters in 1995, LensCrafters had approximately 600 stores. Between 1995 and 1998, we opened new stores and acquired other retail chains, reaching over 850 stores in North America by 1999.
From 1999 to 2004, LensCrafters expansion focused primarily on further development of those stores opened between 1996 and 1998. However, we will continue to evaluate potential retail expansion opportunities in North America through the opening of retail chains and stores in areas where we are not already heavily represented and in other prime locations. As of December 31, 2005, LensCrafters leased 893 retail stores.
Since the LensCrafters acquisition, we have improved the efficiency of LensCrafters stores by managing the inventory from our central worldwide distribution center in Italy. This has improved inventory service and allowed for a more rapid supply of styles based on daily sales and inventory data. This has also increased the percentage of our products available in LensCrafters stores. In addition, we have focused our promotional activities on those customers looking for a better purchase experience with high-quality products, rapid and efficient customer service and innovative lens and frame technology. In order to increase LensCrafters focus on sunglasses, we added a section, one-third sun, devoted only to sunglasses, in many stores. As a result of these initiatives, LensCrafters net sales have increased significantly since 1995.
During the last few years we have shifted LensCrafters to a more premium brand. During this time we have added additional elements such as a new store concept, associate training, advertising and marketing that together represent the premium brand and future direction of LensCrafters.
One of the most visible changes in LensCrafters shift toward a premium and stylish eyewear shopping experience is a new design for the stores, which will be adopted in new and remodeled store locations across North America. The store design features elegant eyewear display boxes, wood flooring, fashion graphics, sleek decorative accents and artistic lighting fixtures. Every feature of the design directs the spotlight on the shopping gallery of designer eyewear collections, while the fit and finish stations are more private and separated from the shopping and frame selection. We have begun to display the eyewear collections by designer brand to help our customers shop for the style that is right for them.
As part of the brand transformation, LensCrafters has rolled out a new style-focused magazine advertising campaign to communicate the brands approach to eyewear style. The ads have appeared in more than two dozen premium fashion,
lifestyle, cultural and entertainment magazines for women and men. Titled Make an Appearance, they are distinguished from other LensCrafters ads, using bold, engaging visuals to emotionally appeal to the fashion and style desires within eyeglass wearers.
Sunglass Hut. With the acquisition of Sunglass Hut in 2001, we became the worlds leading specialty retailer of sunglasses based on sales, and a world leader in specialty retailing of popular priced watches based on sales. Sunglass Hut has about 1,850 retail locations located throughout North America, Europe and Australia. Sunglass Hut operates in-line stores and kiosks in shopping malls, as well as stores in street centers in high-traffic streets and in airports. We have increased sales of Luxottica-manufactured products at Sunglass Hut locations from approximately 14.3 percent of total Sunglass Hut net sales in April 2001 (the first month following the acquisition) to 61.9 percent in December 2005. In addition to sunglasses that we manufacture, Sunglass Hut continues to sell a variety of frames manufactured by third-party vendors, including Oakley Inc., Maui Jim, Inc. and others. Oakley Inc. is our largest third-party supplier, accounting for approximately 8.7 percent, 6.8 percent and 4.9 percent of our total merchandise purchases from suppliers in 2003, 2004 and 2005, respectively. Although we buy products from third parties, including Oakley Inc., we do not believe that the loss of any one supplier would have a siginificant impact on our future operations as we could easily replace lost supply with other sunglasses manufactured by us or other third-party vendors. After the acquisition of Sunglass Hut, we consolidated the administrative and certain other functions of the Sunglass Hut business with our LensCrafters operations allowing us to realize significant synergies between the two optical retailing companies. As of December 31, 2005, Sunglass Hut operated an aggregate of 1,849 outlets throughout North America, Europe and Australia. Sunglass Hut outlets are located mostly in enclosed malls and airports with an average retail space of approximately 500 square feet per kiosk/store.
Cole National. With the acquisition of Cole in October 2004, we acquired a group of distribution outlets and a provider and administrator of managed vision care services under one group. Cole through its wholly owned subsidiaries operates retail vision locations under the name Pearle Vision as well as under the names Sears Optical, Target Optical and BJs Optical, which we refer to as our Licensed Brands. It administers managed vision care programs and benefits previously sold through the Cole Managed Vision Division; renewals and new sales will be through Eyemed Visioncare. Additionally, Cole National operates a chain of personalized gift stores, e-commerce and catalogs under the name Things Remembered. The licensed brands (Sears, Target and BJs) optical retail locations are located in the host stores that bear their names. Pearle Vision stores are mostly located in strip malls outside of the conventional malls where most LensCrafters and Sunglass Hut stores are located. In addition, we have franchised Pearle Vision locations located throughout North America. The Company believes that its combination with Cole will:
strengthen its retail operations in the United States;
strengthen its managed vision care business by increasing the number of people for whom it provides managed vision care benefits as well as by adding well established retailers to its existing family of retailers; and
provide the Company with the opportunity to increase its sales of frames manufactured by the Company in Cole retail stores.
The Company has nearly completed its strategic integration plan with respect to Cole. See Item 5Operating and Financial Review and ProspectsOverview for more information. As of December 31, 2005, Cole operated about 2,400 owned and leased department locations and over 450 franchise locations throughout North America as of December 31, 2005.
We will continue to look to expand our retail operations in North America through opening of new stores or kiosks, or strategic acquisitions when we deem them to be appropriate.
OPSM. In August 2003, we completed the acquisition of 82.57 percent of OPSM, and we completed the acquisition of the minority interest in OPSM in March 2005. This acquisition has resulted in what we believe is a leadership position in the prescription business in the Australian and New Zealand markets and provided us with new growth opportunities in the Asian market. As of December 31, 2005, OPSM had 474 stores in Australia operating under three brands, OPSM, Laubman & Pank and Budget Eyewear, each of which targets a clearly defined market segment. OPSM is the market leader in New Zealand, with 38 stores as of December 31, 2005, and has expanded into Asia, with 66 stores in Hong Kong. OPSM sold its businesses in Singapore and Malaysia during 2005.
Mainland China and Hong Kong. We signed agreements during 2005 to acquire two retailers in the Mainland China retail optical market and an agreement in 2006 to acquire a retailer in Shanghai. The acquisitions are expected to close after receiving customary approvals by the relevant Chinese governmental authorities. These agreements demonstrate our continued commitment to expand our retail presence in strategic markets throughout the world. The acquisitions will give us an additional 238 retail locations in Asia. These additional retail stores are located in premium optical markets in Mainland China. In addition, they will expand our presence in Hong Kong, which we believe to be the most important market in Asia for luxury goods.
Our Principal Markets
The following table presents our net sales by geographic market for the periods indicated:
(1) Adjustment/Eliminations represents the elimination of intercompany sales.
We have also historically experienced sales volume fluctuations by quarter due to seasonality associated with the sale of sunglasses, which represented 55.8 percent and 57.3 percent of our units sold in 2005 and 2004, respectively. As a result, our net sales are typically higher in the second quarter, which includes wholesale sales to customers and increased sales in our Sunglass Hut retail outlets, and lower in the first quarter, as sunglass sales fall in the cooler climates of North America, Europe and Northern Asia. These seasonal variations could affect the comparability of our results from period to period. Our retail fiscal year is either a 53-week year or a 52-week year, which also can affect the comparability of our results from period to period. When a 53-week year occurs, we generally add the extra week to the fourth quarter. A 53-week year occurs in five to six year intervals and is expected to occur again in fiscal 2008.
We produce both metal and plastic frames. In addition to our frame manufacturing capacity, since 1999 we have also produced crystal and polycarbonate sunglass lenses exclusively for our sunglasses collections. Production is principally carried out in our six Italian manufacturing facilities. In China, we produce certain products distributed mainly by our North American retail group and certain finished products for our wholesale business. Each of our facilities is tailored to a specific production technology that we believe allows us to achieve a high level of productivity.
Design and Prototype Selection
We believe that an important aspect of our success has been our emphasis on design and the continuous development of new styles. Our in-house designers work jointly with external designers to develop new models.
For our designer line products, our design team works with licensors to discuss the basic themes and fashion concepts for each product and then works closely with the licensors designers to refine such themes. In addition, our design team works directly with our marketing and sales departments, which monitor demand for our current models as well as general style trends in eyewear. The data obtained from our marketing and sales departments is then used to refine existing product designs and market positioning in order to react to changing consumer preferences.
Once the product concepts have been selected and approved, we produce prototypes that are used to evaluate the proposed design. Our prototypes are developed using computer-aided design/computer-aided manufacturing technology, known as CAD/CAM, which is fully integrated with our manufacturing processes. CAD/CAM technology allows a designer to view and modify two- and three-dimensional images of a new frame. Because this technology is fully integrated with the manufacturing processes, the conversion from prototype to production is streamlined.
All prototypes are subject to review and approval by our licensors and our designers to ensure consistency with the distinctive image of each product line. Our collections consist of both new models and the most successful existing models. Each year, we add approximately 1,500 new models to our eyewear collections. The ability to constantly renew our product base has enabled us to meet consumer demand in each market segment in which our brands are targeted. See Item 3Key InformationRisk Factors If we do not correctly predict future economic conditions and changes in consumer preferences, our sales of premium products and profitability will suffer.
The principal raw materials and parts purchased for our manufacturing process include plastic resins, metals, lenses and frame parts. We purchase a substantial majority of our raw materials in Europe and to a lesser extent in Asia and the United States. In addition, we use certain external suppliers for eyeglass cases and packaging materials. The Ray-Ban acquisition provided us with know-how and sunglass crystal lens manufacturing capabilities. We believe that our ability to produce sunglass crystal lenses is strategically important given our expanded presence in the sunglasses market.
We do not depend on any single supplier for any of our principal raw materials. Although we do not have formal, long-term contracts with our suppliers, we have not experienced any significant interruptions in our supplies. Historically, prices of the principal raw materials used in our manufacturing processes have been stable.
We have six frame manufacturing facilities in Italy. Five facilities are located in northeastern Italy, the area in which most of the countrys optical industry is based, and the remaining facility is located near Turin. All of our facilities are highly automated, which has allowed us to maintain a high level of production without significant capital outlay. In certain of these facilities, we also produce sunglass crystal lenses and polycarbonate lenses. From 1998 to 2001, we operated, through our 50 percent-owned joint venture (Tristar Optical Company Ltd.) with a Japanese partner, a facility in China to manufacture prescription frames for distribution primarily in North America. In 2001, we acquired the remaining 50 percent interest in this Chinese company so that it became one of our wholly-owned subsidiaries.
Over the past several years, we have consolidated our manufacturing processes by tailoring each of our manufacturing facilities in Italy to a specific production technology. This consolidation has allowed us to improve both the productivity and quality of our operations. We produce plastic frames in our facilities in Sedico, Pederobba and Turin, while metal frames are produced in our facilities in Agordo and Rovereto. Certain frame parts are produced in our facility in Cencenighe. In 2005, approximately 56 percent of the frames manufactured by us were metal-based, and the remainder were plastic.
The manufacturing process for both metal and plastic frames and sunglasses begins with the fabrication of precision tooling and molds based on prototypes developed by our in-house design and engineering staff. We believe that our in-house capacity to engineer and produce precision tooling and molds gives us a strong competitive advantage by enabling us to reduce the lead time for product development and thereby adapt quickly to market trends, contain production costs, and maintain smaller and more efficient production runs so that we can better respond to the varying needs of different markets.
The manufacturing process for metal frames is comprised of approximately 70 phases, beginning with the production of basic components such as rims, temples and bridges, which are produced through a molding process. These components are welded together to form frames through numerous stages of detailed assembly work. Once assembled, the metal frames are treated with various coatings to improve their resistance and finish, and then prepared for lens fitting and packaging.
We manufacture plastic frames using either a milling process or injection molding, depending upon the style and color of the frame. In the milling process, a computer-controlled machine carves frames from colored plastic sheets. This process produces rims, temples and bridges that are then assembled, finished and packaged. In the injection molding process, plastic resins are liquefied and injected in molds. The plastic parts are then assembled, coated, finished and packaged.
Our efficient distribution network allows us to track sales and inventory data on a weekly basis. As a result, we are able to:
make and revise manufacturing plans on the basis of current sales information;
reallocate inventory within our wholesale subsidiaries, thereby reducing overall inventory levels and the risk of obsolescence; and
react quickly to changing market trends by providing rapid feedback to our in-house design team.
We engage in research and development activities relating to our manufacturing processes on an on-going basis. As a result of such activities, we have invested, and will continue to invest, in automation, thus increasing efficiency while improving quality. Much of our manufacturing process is automated, including the production of metal and plastic frame parts and the galvanization of metal frames.
One of our key strategic objectives is ensuring the quality of our products. In 1997, we were among the first companies in the eyewear industry to obtain ISO 9001 certifications. Subsequently, in 2003, we obtained the Vision 2000 certification, which is the third-generation industry recognition for quality production. To ensure the high quality of our products, our quality control and process control teams regularly inspect work-in-progress at various stages of the production cycle. In addition, the majority of materials that we purchase are quality tested. We also conduct inspections of, and certify compliance with, the production processes of our main suppliers. Each of our prescription frames and sunglasses undergoes several stages of quality inspection. Due to the efficiency of our quality controls, the return rate for defective merchandise manufactured by us is approximately one percent.
We distribute our products through wholesale and retail channels.
Distribution by Wholesale Division
We currently distribute our products in approximately 120 countries and operate 29 wholly or partially owned wholesale distribution subsidiaries strategically located in major markets worldwide. In markets where we do not have wholesale distribution subsidiaries, we employ approximately 100 independent distributors.
Each wholesale distribution subsidiary operates its own network of sales representatives, who are normally retained on a commission basis. Our network of wholesale distribution subsidiaries represents a key element of our business. We believe that control over an extensive distribution network provides us with a competitive advantage, because it enables us to maximize our brand image, marketing efforts and customer service activities by tailoring our operations to meet the specific needs and peculiarities of local markets.
The following table sets forth certain information regarding our wholesale distribution subsidiaries and affiliates:
(1) The shares of Ray Ban Sun Optics India Ltd. are publicly traded on the BSE Stock Exchange, Mumbai. Because we do not own a 50% equity interest in the entity, we account for this entity under the equity method of accounting.
We maintain close contact with our distributors in order to monitor sales and to control the quality of the points of sale that display products. We typically enter into distribution agreements with importers and distributors that establish minimum annual purchases and impose territorial limitations. In addition, to the extent permitted by law, we allow for distribution only through specifically authorized retail channels and qualified sales agents.
No single customer or group of related customers accounted for more than two percent of our consolidated net sales in any of the past three years. We do not believe that the loss of any single customer would have a material adverse effect on our financial condition or results of operations.
Our distribution system is integrated internationally. A worldwide computerized information network links the distribution and sales systems with the production facilities in Italy. This network enables us to monitor worldwide sales trends and inventory positions on a daily basis and to allocate production resources accordingly.
We believe that one of our key competitive strengths is our ability to promptly satisfy customer demand in a timely manner, both prior to and following a sale. In order to further improve our customer service capabilities, we have centralized our distribution centers in Europe (Italy) and Asia (Japan) and are in the final stages of centralizing our distribution centers in North America (United States). We believe that centralizing our distribution centers improves the efficiency of our distribution operations while reducing the related costs.
Distribution by Retail Division
Through our Retail Division, we believe we operate the largest group of optical superstores in both the United States and Canada based on both sales and store count. We believe we are the largest specialty retailer of sunglasses in the world based on 2005 revenues and believe we have become a leading player in the Australian prescription segment. We also sell watches and accessories in certain sunglass retail locations and under the store names Watch World and Watch Station and personalized gifts under the name Things Remembered.
In our optical retail stores, customers can choose from a large selection of frames and lenses offering a high level of comfort and fit. LensCrafters customers can obtain a completed pair of prescription glasses in approximately one hour because of on-site lens grinding laboratories. In our Sunglass Hut locations, customers can choose from a large selection of Luxottica and third-party vendor manufactured sunglasses. In addition, Sunglass Hut locations can assist customers in purchasing other accessories to complement their sunglasses. As of December 31, 2005, our retail division consisted of 5,679 owned or leased department retail locations and 491 franchised locations as follows:
* Asia-Pacific for our Retail Division consists of Australia, New Zealand, Malaysia, Singapore and Hong Kong.
In 2005, approximately 68.4 percent, 12.5 percent, 21.2 percent and 61.9 percent of the total sales of frames based on units sold by LensCrafters, Cole, OPSM and Sunglass Hut, respectively, were produced by our manufacturing facilities. OPSM was acquired in August 2003 and at such time 3.5 percent of the total sales of frames sold were produced by our manufacturing facilities. Cole National was acquired in October 2004, and at such time less than 1 percent of the total sales of frames sold were produced by our manufacturing facilities. The Retail Divisions outlets sell not only frames that we manufacture but also a wide range of frames, lenses and other ophthalmic products manufactured by other companies.
Substantially all LensCrafters, Cole National and OPSM stores have an employed or independent optometrist on site, allowing the customer to have an eye examination, select from a large range of prescription eyewear, and receive the selected frame with prescription lenses from one location. In addition, substantially all of our LensCrafters stores have a lens grinding laboratory on site, which allows our customers to receive a complete set of prescription frames or sunglasses in approximately one hour.
The prescription frame and sunglasses industry is highly competitive and fragmented. As we market our products throughout the world, we compete with many prescription frame and sunglasses companies in various local markets. We believe that our principal competitor in the design, manufacture and distribution of eyewear within the prescription frames market is Safilo Group S.p.A., or Safilo. We believe that our principal competitors in the sunglasses market include Safilo, De Rigo S.A. and Oakley, Inc. Several of our most significant competitors in the manufacture and distribution of eyewear are significant vendors to our Retail Division. Our success in these markets will depend on, among other things, our ability to manage an efficient distribution network and to market our products effectively as well as on the popularity and market acceptance of our brands. See Item 3Key InformationRisk FactorsIf we are unable to successfully introduce new products, our future sales and operating performance will suffer and The markets in which we compete are highly competitive, and our failure to maintain an efficient distribution network could harm our business.
The highly competitive optical retail market in North America includes a large number of small independent competitors and several national and regional chains of optical superstores. In recent years, a number of factors, including consolidation among retail chains and the emergence of optical departments in discount retailers, have resulted in significant competition within the optical retailing industry. We compete against several large optical retail chains in North America, including Wal-Mart and Eye Care Centers of America, and, in the sunglasses area, numerous sunglass outlet centers. Our optical retail operations emphasize product quality, selection, customer service and convenience. We do not compete primarily on the basis of price.
Our marketing and advertising activities are designed primarily to enhance the image of Luxottica and our brand portfolio and to drive traffic into our retail locations. Advertising expenses amounted to approximately six percent of our net sales in each of 2003, 2004 and 2005.
Marketing Strategy for Our Wholesale Business
Our marketing strategy in the wholesale distribution segment is focused on promoting our extensive brand portfolio, our corporate image and the value of our products. Advertising is extremely important in supporting our marketing strategy, and we therefore engage in extensive advertising activities, both at the point-of-sale and through various media directed at the end consumer of our products.
Our point-of-sale marketing materials consist of displays, counter cards, catalogs, posters and product literature . Many of these materials are linked to our consumer advertising campaigns.
In our media advertising, we utilize direct media, such as print, radio and television, as well as billboard advertising. The extent of our advertising activities and the selection of different media depend upon the competitive conditions in each particular market. In addition, we advertise in publications targeted to independent practitioners and other market-specific magazines.
We also benefit from brand-name advertising carried out by licensors of our designer lines intended to promote the image of the designer line. Our advertising and promotional efforts in respect of our licensed brands are developed in coordination with our licensors. We contribute to the designer a specified percentage of our sales of the designer line to be devoted to advertising and promotion.
Finally, we participate in major industry trade fairs (including the MIDO fair in Milan, Vision Expo in the United States and the SILMO in Paris), where our new collections are displayed and promoted to the market.
Marketing Strategy for Our Retail Business
In addition to the marketing activities described above, we engage in promotional and advertising activities through our Retail Division with both short- and long-term objectives. Our short-term objectives are to attract customers to our stores and promote sales. Our long-term objective is to build the image and visibility of our retail brands throughout the world, such as the LensCrafters and Pearle Vision brands in North America, the Sunglass Hut brand worldwide, the OPSM, Laubman & Pank and Budget Eyewear brands in Australia and New Zealand, thereby encouraging customer loyalty and return purchases. We believe that the product quality and service provided by our Retail Division contribute to our short- and long-term marketing objectives.
A considerable amount of our Retail Divisions marketing budget is dedicated to direct marketing activities, such as communications with customers (e.g., mailings and catalogues). Our direct marketing activities benefit from our large database of customer information in the United States and in Australia. Another significant portion of the marketing budget is allocated to broadcast and print media (e.g., television, radio and magazines) designed to reach the broad markets in which we operate with image-building messages about our retail business.
Trademarks, Trade Names and License Agreements
Trademarks and Trade Names
As of December 31, 2005, our principal trademarks or trade names included Luxottica, Ray-Ban, Persol, Vogue, LensCrafters, Sunglass Hut, Pearle Vision and OPSM. Our principal trademarks are registered in several countries. Other than Luxottica, Ray-Ban, LensCrafters, Sunglass Hut, Pearle Vision and OPSM, we do not believe that any single trademark or trade name is material to our business or results of operations. Ray-Ban products accounted for approximately 12.2 percent of our net sales in 2005. Management believes that our trademarks have significant value in marketing our products.
LensCrafters has introduced several trademarked lenses in recent years that contain innovative technology, such as FeatherWatesÔ (lightweight, thin and impact resistant lenses), FeatherWates Complete with ScotchgardÔ (thin, light, scratch and impact resistant, anti-reflective and easy-to-clean lenses), DURALENSÔ (super scratch-resistant lenses), InvisiblesÔ (anti-reflective lenses) and MVP Maximum View Progressives (multi-focal lenses without visible lines). LensCrafters purchases these lenses under non-exclusive arrangements with third parties. The names of the lenses used by LensCrafters are typically trademarked, and the trademarks are typically owned by us. OPSM has trademarked several lenses in recent years that it uses in its advertising. They include ActiviseÔ for contact lenses, ActiveÔ for polycarbonate eyeglass lenses and InvisiblesÔ for multi-coated eyeglass lenses.
We do not have any patents that we believe are, individually or in the aggregate, material to our results of operations or financial condition.
See Item 3 Key InformationRisk FactorsIf we are unable to protect our proprietary rights, the loss of sales and the costs of defending such rights will adversely affect our business and financial results.
We have entered into certain license agreements to manufacture and distribute prescription frames and sunglasses with numerous designers. These license agreements have terms expiring through 2022. The table below summarizes the principal terms of our most significant license agreements as of June 15, 2006.
* Retail Brand Alliance, Inc. is indirectly owned and controlled by one of our directors.
** Adrienne Vittadini LLC is indirectly owned and controlled by one of our directors.
*** U.S., Canada, Mexico and Japan only.
Under these license agreements, we are required to pay a royalty which generally ranges from five percent to twelve percent of net sales of the relevant collection, which may be offset by any guaranteed minimum royalty payments. The license agreements also provide for a mandatory marketing contribution that generally amounts to five percent of net sales. The particular licensor is responsible for the manner and form of advertising for its collection. Other than the license agreement for the Moschino line, which is terminable upon 12 months notice, these license agreements typically have terms ranging from three to ten years, but may be terminated early by either party for a variety of reasons, including non-payment of royalties, failure to meet minimum sales thresholds, product alteration and, under certain agreements, any change in the ownership of the ordinary shares resulting in a change in control of Luxottica Group S.p.A.
No single designer line accounted for more than five percent of net sales for the year ended December 31, 2005. Management believes that, while the early termination of one or a small number of the current license agreements may have an adverse effect on our results of operations in the short term, any such termination would not have a material adverse effect on our long-term results of operations or financial condition. Upon any early termination of an existing license agreement, we expect that we would seek to enter into alternative arrangements with other designers to reduce any negative impact of such a termination.
Our products are subject to governmental health safety regulations in most of the countries where they are sold, including the United States. We regularly inspect our production techniques and standards to ensure compliance with applicable requirements. Historically, compliance with such requirements has not had a material effect on our operations.
In addition, governments throughout the world impose import duties and tariffs on products being imported into their countries. Although in the past we have not experienced situations in which the duties or tariffs imposed materially impacted our operations, we can provide no assurances that this will be true in the future.
Our past and present operations, including owned and leased real property, are subject to extensive and changing environmental laws and regulations pertaining to the discharge of materials into the environment, the handling and disposition of wastes or otherwise relating to the protection of the environment. We believe that we are in substantial compliance with the applicable environmental laws and regulations. However, we cannot predict with any certainty that we will not in the future incur liability under environmental statutes and regulations with respect to contamination of sites formerly or currently owned or operated by us (including contamination caused by prior owners and operators of such sites) and the off-site disposal of hazardous substances.
Our retail operations are also subject to various state or similar legal requirements in the United States, Australia, Canada, New Zealand, Hong Kong, Singapore and Malaysia that regulate the permitted relationships between licensed optometrists or ophthalmologists, who primarily perform eye examinations and prescribe corrective lenses, and opticians, who fill such prescriptions and sell eyeglass frames.
We are a holding company, and virtually all of our operations are conducted through our wholly-owned subsidiaries. We operate in two industry segments: (i) manufacturing and wholesale distribution, and (ii) retail distribution. In the retail segment, we primarily conduct our operations through LensCrafters, Sunglass Hut, Pearle Vision, Cole Licensed Brands and OPSM. In the manufacturing and wholesale distribution segment, we operate through approximately six manufacturing subsidiaries and 29 geographically oriented wholesale distribution subsidiaries. See Distribution for a breakdown of the geographic areas.
The significant subsidiaries controlled by Luxottica Group S.p.A., including holding companies, as of December 31, 2005, were:
Property, Plants and Equipment
Our corporate headquarters is located at Via Cantù 2, Milan, Italy. Information regarding the location, use and approximate size of our principal offices and facilities as of December 31, 2005 is set forth below:
(1) The property located in Valbonne (France) is leased (with an option to purchase the underlying property at the end of the lease term for a nominal price) by our wholly-owned subsidiary in France.
As of December 31, 2005, LensCrafters leased 893 retail stores, Sunglass Hut leased 1,849 retail kiosks or stores,
Cole National leased 1,724 optical retail locations including licensed departments in host stores and 664 Things Remembered retail locations, and OPSM leased 549 retail stores. Such leases expire between 2006 through 2025 and have terms that we believe are generally reasonable and reflective of market conditions.
We believe that our current facilities (including our manufacturing capacity) are adequate to meet our present and reasonably foreseeable needs except for the North American Retail Division Headquarters located in Mason, Ohio which began in early 2005 to undergo an expansion of approximately 127,000 square feet at a projected cost of U.S. $13.5 million. This expansion is expected to be completed in 2006 and is part our integration of Cole National operations into our existing North American retail headquarters. Other than the capital lease for our offices in Valbonne (France), there are no material encumbrances on any owned properties.
Our capital expenditures were Euro 229.4 million for the year ended December 31, 2005 and Euro 42.5 million for the three-month period ended March 31, 2006. It is our expectation that 2006 annual capital expenditures will be approximately Euro 200 million, in addition to investment for any acquisitions. We will pay for these future capital expenditures with our current available borrowing capacity and available cash. For a description of capital expenditures for the previous three years, see Item 5Operating and Financial Review and ProspectsLiquidity and Financial ResourcesOur Cash FlowsInvesting Activities.
We operate in two industry segments: (i) manufacturing and wholesale distribution and (ii) retail distribution. Through our manufacturing and wholesale distribution segment, we are engaged in the design, manufacture, wholesale distribution and marketing of house brand and designer lines of mid- to premium-priced prescription frames and sunglasses. During the periods discussed below, we have operated in the retail segment through our Retail Division, comprised principally of LensCrafters, Sunglass Hut, since August 2003, OPSM and since October 2004, Cole . As of December 31, 2005, the retail segment consisted of 5,679 owned or leased department retail locations and 491 franchised locations as follows:
*Asia-Pacific for our Retail Division consists of Australia, New Zealand, Malaysia, Singapore and Hong Kong.
LensCrafters and Cole have retail distribution operations located throughout the United States, Canada and Puerto Rico, while OPSM operates retail outlets located in Australia, New Zealand, Hong Kong, Singapore and Malaysia. Sunglass Hut is a leading retailer of sunglasses worldwide based on sales.
Our net sales consist of direct sales of finished products that we manufacture to opticians and other independent retailers through our wholesale distribution channel and sales directly to consumers through our Retail Division retail channel. Our average retail unit selling price is significantly higher than our average wholesale unit selling price, as our retail sales typically include lenses as well as frames.
Demand for our products, particularly our higher-end designer lines, is largely dependent on the discretionary spending power of the consumers in the markets in which we operate. See Item 3Key InformationRisk FactorsIf we do not correctly predict future economic conditions and changes in consumer preferences, our sales of premium products and profitability will suffer. We have also historically experienced sales volume fluctuations by quarter due to seasonality associated with the sale of sunglasses. As a result, our net sales are typically higher in the second quarter and lower in the first quarter.
Our acquisitions have affected our results of operations from year to year. Our results of operations for the year ended December 31, 2004 are not comparable to the results of operations for the year ended December 31, 2003 and prior years due to the inclusion of the operations of Cole beginning in October 2004.
As a result of our acquisition of LensCrafters in May 1995 and the subsequent expansion of our business activities in the United States through the acquisition of the Ray-Ban business, Sunglass Hut and Cole, our results of operations, which are reported in Euro, have been rendered more susceptible to currency rate fluctuations between the Euro and the U.S. dollar. The U.S. dollar/Euro exchange rate has fluctuated from an average exchange rate of Euro 1.00 = U.S. $1.1307 in 2003 to Euro 1.00 = U.S. $1.2435 in 2004 to Euro 1.00 = U.S. $1.2444 in 2005. Additionally, with the acquisition of OPSM, our results of operations have been rendered susceptible to currency fluctuations between the Euro and the A$. Although we engage in certain foreign currency hedging activities to mitigate the impact of these fluctuations, they have impacted our reported revenues and expenses during the periods discussed herein. See Item 11Quantitative and Qualitative Disclosures About Market RiskForeign Exchange Sensitivity and Item 3Key InformationRisk FactorsIf the Euro strengthens relative to certain other currencies, our profitability as a consolidated group will suffer.
On November 26, 2004, we, through our wholly-owned subsidiary, Luxottica South Pacific Pty, Ltd., made an offer for all the remaining outstanding shares of OPSM that we did not already own. The offer was for A$4.35 per share including a fully franked dividend of A$0.15 per share that was declared by OPSM (resulting in a net price of A$4.20 per share). On January 4, 2005, we launched an off-market takeover offer for all the Australian Stock Exchangelisted OPSM shares we did not already own. At the close of the offer on February 7, 2005, we held 98.5 percent of OPSM shares, which is in excess of the compulsory acquisition threshold. On February 8, 2005, we announced the start of the compulsory acquisition process for all remaining shares in OPSM not already owned by us. On February 15, 2005, the Australian Stock Exchange suspended trading in OPSM shares and on February 18, 2005, it delisted OPSM shares from the Australian Stock Exchange. The compulsory acquisition process was completed on March 24, 2005.
On October 4, 2004, we acquired all of the issued and outstanding shares of Cole through a merger. The aggregate consideration paid by us to former shareholders, option holders and holders of restricted stock of Cole was $500.6 million. In connection with the merger, we assumed outstanding indebtedness with an approximate aggregate fair value of the principal balance of $310.9 million. We believe that our combination with Cole has:
· strengthened our retail operations in the United States;
· strengthened our managed vision care business by increasing the number of people for whom we provide managed vision care benefits as well as by adding well established retailers to its existing family of retailers; and
· provided us with the opportunity to increase our sales of frames manufactured by the Company in Cole retail stores.
We have substantially completed our strategic integration plan with respect to Cole. Since the consummation of the acquisition, we have consolidated Coles headquarters with our Luxottica Retail headquarters in Mason, Ohio, and combined various general and administrative functions.
The integration of our corporate, financial and human resources systems is now complete.
Our integration plans also include combining Luxottica Retails and Coles operating systems. We have integrated the inventory management and assortment planning systems. We plan to integrate the distribution centers by the end of 2006.
In October 2005, we integrated our Managed Vision Care system with Coles, resulting in a single brand (EyeMed) going forward. We have already begun to sell the new combined product.
We expect that our North American retail operating margin levels will return to 2004 pre-acquisition operating margin levels by the end of 2006.
Our integration with Cole has resulted in synergies in the following areas:
· general and administrative; and
· sale of the Companys manufactured products.
We have substantially executed our integration plans and have begun to realize the anticipated cost savings.
Critical Accounting Policies
The preparation of financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities as of the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Our estimates are based on historical experience and currently available information. Our significant accounting policies are discussed in Note 1 to our Consolidated Financial Statements included in Item 18 of this annual report. The following is a discussion of what management believes are our most critical accounting policies:
Revenues include sales of merchandise (both wholesale and retail), insurance and administrative fees associated with the Companys managed vision care business, eye exams and related professional services and sales of merchandise to franchisees, along with other revenues from franchisees such as royalties based on sales and initial franchise fee revenues.
In some countries, the wholesale and retail divisions offer the customer the right to return products for a limited period of time after the sale. However, such right of return does not impact the timing of revenue recognition as all conditions of SFAS No. 48, Revenue Recognition When Right of Return Exists, are satisfied at the date of sale. We have estimated and accrued for the amounts to be returned in the subsequent period. This estimate is based on our right of return policies and practices along with historical data, sales trends and the timing of returns from the original transaction date when applicable. Changes to these policies and practices or a change in the trend of returns could lead to actual returns being different from the amounts estimated and accrued.
Also included in Retail Division revenues are managed vision care revenues consisting of (i) insurance revenues which are recognized when earned over the terms of the respective contractual relationships and (ii) administrative services revenues which are recognized when services are provided during the contract period. Accruals are established for amounts due under these relationships determined to be uncollectible. Our insurance contracts require us to estimate the potential costs and exposures over the life of the agreement such that the amount charged to the customers will cover these costs. To mitigate the exposure risk, these contracts are usually short-term in nature. However, if we do not accurately estimate the future exposure and risks associated with these contracts, we may suffer losses as we would not be able to cover our costs incurred with revenues from the customer.
Income taxes are recorded in accordance with SFAS No. 109, Accounting for Income Taxes, which requires recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been included in our consolidated financial statements or tax returns. Under this method, deferred tax liabilities and assets are determined based on the difference between the consolidated financial statement and tax basis of assets and liabilities using enacted tax rates in effect for the year in which the differences are expected to reverse. A valuation allowance is recorded for deferred tax assets if it is determined that it is more likely than not that the asset will not be realized. These estimated tax rates and the deferred tax assets, including valuation allowances placed upon those deferred tax assets, and liabilities recorded are based on information available at the time of calculation. This information is subject to change due to subsequent tax audits performed by different taxing jurisdictions and changes in corporate structure not contemplated at the time of calculation, as well as various other factors.
Our manufactured inventories were approximately 65.0 percent and 75.4 percent of total frame inventory for 2004 and 2005, respectively. All inventories at December 31, 2005 were valued using the lower of cost (as determined under a weighted-average method which approximates the first in, first out method) or market. At December 31, 2004, certain retail inventory not manufactured by us was valued using the last in, first out method (LIFO). However, in order to reduce the inventory methods among different companies in the retail group and to simplify the process of valuing inventory, we changed the method of acccounting for inventory valuation to the first in, first out method. This change had an immaterial effect on our consolidated financial statements. Inventories are recorded net of allowances for possible losses among other reserves. These reserves are calculated using various factors including quantity on hand, sales volume, historical shrink results, changes in market conditions and current trends. In addition, production schedules are made on similar factors which, if not estimated correctly, could lead to the production of potentially obsolete inventory. As such, actual results could differ significantly from the estimated amounts.
Goodwill and Other Intangible Assets and Impairment of Long-Lived Assets
In connection with various acquisitions, we have recorded as intangible assets certain goodwill and trade names. At December 31, 2005, the aggregate carrying value of intangibles, including goodwill, was approximately Euro 2.7 billion or approximately 54 percent of total assets.
Effective January 1, 2002, we adopted SFAS No. 142, Goodwill and Other Intangible Assets (SFAS No. 142). Under SFAS No. 142, goodwill and intangible assets deemed to have an indefinite life are no longer amortized in the same manner as under the previous standards, but rather are tested for impairment annually and, under certain circumstances, between annual periods. An impairment charge will be recorded if the fair value of goodwill and other intangible assets is less than the carrying value. The calculation of fair value may be based on, among other items, estimated future cash flows if quoted market prices in active markets are not available. We test our goodwill for impairment annually as of December 31 of each year and any other time a condition arises that may cause us to believe that an impairment has occurred. Since impairment tests use estimates of the impact of future events, actual results may differ and we may be required to record an impairment in future years.
Intangibles subject to amortization based on a finite useful life continue to be amortized on a straight-line basis over their useful lives. Our long-lived assets, other than goodwill, are tested for impairment whenever events or changes in circumstances indicate that the net carrying amount may not be recoverable. When such events occur, we measure impairment by comparing the carrying value of the long-lived asset to the estimated undiscounted future cash flows expected to result from the use of the assets and their eventual disposition. If the sum of the expected undiscounted future cash flows were less than the carrying amount of the assets, we would recognize an impairment loss, if determined to be necessary. Actual results may differ from our current estimates.
Recent Accounting Pronouncements
In November 2004, the Financial Accounting Standards Board (FASB) issued SFAS No. 151, Inventory Costs an amendment of ARB No. 43, Chapter 4, to clarify that abnormal amounts of idle facility expense, freight, handling costs, and wasted material should be recognized as period costs. In addition, this statement requires that the allocation of fixed production costs of conversion be based on the normal capacity of the production facilities. The adoption of such standard is required for fiscal years beginning after June 15, 2005. We believe that the adoption will not have a material effect on our consolidated financial statements.
In December 2004, the FASB issued SFAS No. 123-R (revised 2004), Share-Based Payment (SFAS 123-R) which replaces the existing SFAS 123 and supersedes APB 25. SFAS 123-R requires companies to measure and record compensation expense for stock options and other share-based payment methods based on the instruments fair value. SFAS 123-R is effective for us on January 1, 2006. We have evaluated the impact of the adoption of SFAS No. 123-R and determined that the additional compensation cost which would have been recorded in fiscal 2005 is not material.
In December 2004, the FASB issued SFAS No. 153, Exchanges of Nonmonetary Assets an amendment of APB Opinion No. 29 (SFAS 153). SFAS 153 amends APB No. 29, Accounting for Nonmonetary Transactions, to eliminate the exception for nonmonetary exchanges of similar productive assets and replaces it with a general exception for exchanges of nonmonetary assets that do not have commercial substance. A nonmonetary exchange has commercial substance if the future cash flows of the entity are expected to change significantly as a result of the exchange. SFAS 153 is effective for reporting periods beginning after June 15, 2005. The adoption of SFAS 153 is not expected to have a material effect on our consolidated financial statements.
In March 2005, the FASB issued Interpretation No. 47, Accounting for Conditional Asset Retirement Obligationsan Interpretation of FASB Statement No. 143 (FIN 47), which clarifies the term conditional asset retirement obligation as used in SFAS 143 and requires the recognition of a liability for a conditional asset retirement obligation if the fair value of the liability can be reasonably estimated. FIN 47 is effective for reporting periods beginning after December 15, 2005. The adoption of FIN 47 is not expected to have a material effect on our consolidated financial statements.
In May 2005, the FASB issued SFAS No. 154, Accounting Changes and Error Correctionsa replacement of APB Opinion No. 20 and FASB Statement No. 3 (SFAS 154). SFAS 154 applies to all voluntary changes in accounting principles and changes required by accounting pronouncements in instances where the pronouncement does not include specific transition provisions. This Statement replaces APB No. 20, Accounting Changes, and SFAS No. 3, Reporting Accounting Changes in Interim Financial Statements. SFAS 154 requires retroactive application to prior periods financial statements of changes in accounting principles unless it is impracticable to do so. SFAS 154 is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005.
In June 2005, the Emerging Issues Task Force (EITF) reached a consensus on Issue No. 05-6, Determining the Amortization Period for Leasehold Improvements (EITF 05-6), which requires that leasehold improvements acquired in a business combination or purchased significantly after, and not contemplated at the inception of the lease be amortized over the lesser of the useful life of the asset or a term that includes lease renewals that are reasonably assured. EITF 05-6 is applicable for leasehold improvements acquired or purchased beginning after June 29, 2005 and will be followed in future periods if and when necessary.
In October 2005, the FASB issued Staff Position No. 13-1, Accounting for Rental Costs Incurred During a Construction Period (FSP 13-1), that concluded rental costs associated with ground and building operating leases that are incurred during the construction period should be recognized as rental expense in such period. This guidance is effective for reporting periods beginning after December 15, 2005. The adoption of FSP 13-1 is not expected to have a material effect on our consolidated financial statements and will be followed in future periods if and when necessary.
In February 2006, the FASB issued SFAS No. 155, Accounting for Certain Hybrid Financial Instrumentsan Amendment of FASB Statements No. 133 and 140 (SFAS 155), which amends SFAS 133, and SFAS 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities. The statement:
· Permits fair value remeasurement for any hybrid financial instrument that contains an embedded derivative that otherwise would require bifurcation;
· Clarifies which interest-only strips and principal-only strips are not subject to the requirements of Statement No. 133;
· Establishes a requirement to evaluate interests in securitized financial assets to identify interests that are freestanding derivatives or that are hybrid financial instruments that contain an embedded derivative requiring bifurcation;
· Clarifies that concentrations of credit risk in the form of subordination are not embedded derivatives; and
· Amends Statement No. 140 to eliminate the prohibition on a qualifying special-purpose entity from holding a derivative financial instrument that pertains to a beneficial interest other than another derivative financial instrument.
SFAS 155 is effective for all financial instruments acquired or issued after the beginning of an entitys first fiscal year that begins after September 15, 2006. The adoption of SFAS 155 is not expected to have a material effect on our consolidated financial statements.
Results of Operations
The following table sets forth, for the periods indicated, the percentage of net sales represented by certain items included in our statements of consolidated income:
For additional financial information by operating segment and geographic region, see Note 12 to our Consolidated Financial Statements included in Item 18 of this annual report.
Comparison of the year ended December 31, 2005 to the year ended December 31, 2004
Net Sales. Net sales increased 34.3 percent to Euro 4,370.7 million during 2005 as compared to Euro 3,255.3 million for 2004.Net sales in the retail segment, through LensCrafters, Sunglass Hut, OPSM and Cole, increased by 40.5 percent to Euro 3,298.2 million for 2005 from Euro 2,346.7 million for 2004. This increase was primarily due to the inclusion of Cole sales from the date of acquisition on October 4, 2004, which amounted to Euro 998.0 million for the full fiscal year 2005 compared to Euro 240.5 million for the three-month period following the acquisition in 2004.
Net sales to third parties in the manufacturing and wholesale segment increased by 18.3 percent to Euro 1,075.0 million for 2005 as compared to Euro 908.6 million in 2004. This increase was mainly attributable to increased sales of our Ray-Ban brand, as well as Prada, Versace, Bulgari and Dolce & Gabbana (which we began distributing in October 2005). Wholesale sales were strong in all geographic areas.
On a geographic basis net of intercompany transactions, operations in North America resulted in net sales of Euro 3,048.3 million during 2005, comprising 69.7 percent of total net sales, an increase of Euro 964.8 million from 2004. This increase was primarily due to the inclusion of Cole sales from the date of acquisition on October 4, 2004, which amounted to Euro 998.0 million for the full fiscal year 2005 compared to Euro 240.5 million for the three-month period following the acquisition in 2004. This sales increase was mostly driven by our focus on selling premium frames and products at both our Sunglass Hut and LensCrafters North American retail outlets. This focus included the remodeling, opening or relocation of over 250 Sunglass Hut outlets. Net sales for operations in Asia-Pacific, which consists of Australia, New Zealand, Singapore, Malaysia, Hong Kong, Thailand, China, Japan and Taiwan, were Euro 461.2 million during 2005, comprising 10.6 percent of total net sales, an increase of Euro 26.2 million as compared to 2004. Net sales for the rest of the world accounted for the remaining Euro 861.2 million of net sales during 2005, which represented a 16.9 percent increase as compared to 2004.
During 2005, net sales in the retail segment accounted for approximately 75.4 percent of total net sales, as compared to approximately 72.1 percent of total net sales in 2004 due to the retail acquisition described above.
Cost of Sales. Cost of sales increased by 32.7 percent to Euro 1,380.7 million in 2005 from Euro 1,040.7 million in 2004. Cost of sales in the retail segment increased by Euro 315.4 million, which increase is primarily attributable to the inclusion of Cole in our results of operations for three months in 2004 compared to a full 12 months in 2005. Cost of sales in the manufacturing and wholesale segment increased by Euro 68.6 million due to the increase in net sales. As a percentage of net sales, cost of sales decreased to 31.6 percent from 32.0 percent. This was mostly attributable to the placement of more Luxottica manufactured products in our newly acquired Cole retail locations. Manufacturing labor costs increased by 17.3 percent to Euro 301.4 million in 2005 from Euro 256.9 million in 2004. This increase is attributable to the increase in net sales. As a percentage of net sales, cost of labor decreased to 6.9 percent in 2005 from 7.9 percent in 2004, due to higher productivity in the wholesale division, as well as due to the inclusion of Cole results, since Coles cost of labor as a percentage of sales is lower than that of the rest of the Group. For 2005, the average number of frames produced daily in our facilities (including Tristar, our Chinese factory) was approximately 125,000, which was in line with 2004 production.
Gross Profit. For the reasons outlined above, gross profit increased by 35.0 percent to Euro 2,990.1 million in 2005, from Euro 2,214.6 million in 2004. As a percentage of net sales, gross profit increased to 68.4 percent in 2005 from 68.0 percent in 2004.
Operating Expenses. Total operating expenses increased by 38.7 percent to Euro 2,387.5 million in 2005 from Euro 1,721.8 million in 2004. As a percentage of net sales, operating expenses increased to 54.6 percent in 2005 from 52.9 percent in 2004.
Selling and advertising expenses, including royalty expenses, increased by 38.7 percent to Euro 1,909.7 million during 2005 from Euro 1,376.5 million in 2004. Euro 399.3 million of this increase is attributable to the inclusion of Cole in our results of operations for the full fiscal year in 2005 compared to only the fourth quarter of 2004 (from the date of acquisition). As a percentage of net sales, selling and advertising expenses increased to 43.7 percent in 2005 from 42.3 percent in 2004. This increase as a percentage of sales is primarily attributable to the consolidation of Coles results in our results of operations.
General and administrative expenses, including intangible asset amortization, increased by 38.4 percent to Euro 477.8 million in 2005 from Euro 345.2 million in 2004. Euro 90.1 million of this increase is attributable to the inclusion of Cole in our results of operations for the full fiscal year in 2005 compared to only the fourth quarter of 2004 (from the date of acquisition). As a percentage of net sales, general and administrative expenses increased to 10.9 percent in 2005 from 10.6 percent in 2004. This increase was primarily due to the consolidation of Cole results in our results of operations. As we continue the integration of Cole, we expect its operating expenses as a percentage of sales to decrease due to the expected higher efficiency in the fixed cost structure.
Income from Operations. For the reasons outlined above, income from operations for 2005 increased by 22.3 percent to Euro 602.6 million from Euro 492.8 million in 2004. As a percentage of net sales, income from operations decreased to 13.8 percent in 2005 compared to 15.1 percent for 2004.
Operating margin, calculated as income from operations divided by net sales, in the manufacturing and wholesale distribution segment increased to 23.2 percent in 2005 from 21.3 percent in 2004. This increase in operating margin is attributable to higher efficiency in our fixed cost structure driven by increases in net sales and lower sales commissions, partially offset by higher advertising expenses.
Operating margin in the retail segment decreased to 11.5 percent in 2005 from 13.2 percent in 2004, due to the inclusion of the results for Cole, whose operating margin is lower than that of our other retail chains. However, we believe that when the final restructuring of the North American Retail Division is completed by the end of 2006, we will return to our historical operating margins.
Other Income (Expense)-Net. Other income (expense)-net was a net expense of Euro 45.0 million in 2005 as compared to a net expense of Euro 35.7 million in 2004. This increase in other income (expense)-net is mainly attributable to an increase in interest expense of Euro 11.2 million due to the debt incurred for the acquisition of Cole, as well as rising interest rates. We expect an increase in interest expense for 2006 due to the rising interest rate environment.
Net Income. Income before taxes increased by 22.0 percent to Euro 557.6 million in 2005 from Euro 457.2 million in 2004. As a percentage of net sales, income before taxes decreased to 12.8 percent in 2005 from 14.0 percent in 2004, mainly due to the integration of the Cole operations. Minority interest increased to Euro (9.3) million in 2005 from Euro (8.6) million in 2004. Our effective tax rate was 37.0 percent in 2005, while it was 35.4 percent in 2004. Net income increased by 19.3 percent to Euro 342.3 million in 2005 from Euro 286.9 million in 2004. Net income as a percentage of net sales decreased to 7.8 percent in 2005 from 8.8 percent in 2004.
Basic earnings per share for 2005 were Euro 0.76, increasing from Euro 0.64 for 2004. Diluted earnings per share for 2005 were Euro 0.76, increasing from Euro 0.64 for 2004.
Non-GAAP Financial Measures
We use certain measures of financial performance that exclude the impact of fluctuations in currency exchange rates in the translation of operating results into Euro, and include the results of operations of Cole for the full year 2004. We believe that these adjusted financial measures provide useful information to both management and investors by allowing a comparison of operating performance on a consistent basis. In addition, since we have historically reported such adjusted financial measures to the investment community, we believe that their inclusion provides consistency in our financial reporting. Further, these adjusted financial measures are one of the primary indicators management uses for planning and forecasting in future periods. Operating measures that assume constant exchange rates between 2005 and 2004 are calculated using, for each currency, the average exchange rate for the year ended December 31, 2004.
Operating measures that exclude the impact of fluctuation in currency exchange rates are not measures of performance under U.S. GAAP. These non-GAAP measures are not meant to be considered in isolation or as a substitute for results prepared in accordance with U.S. GAAP. In addition, our method of calculating operating performance to exclude the
impact of changes in exchange rates may differ from methods used by other companies. See the table below for a reconciliation of the operating measures excluding the impact of fluctuations in currency exchange rates to their most directly comparable U.S. GAAP financial measures. The adjusted financial measures should be used as a supplement to results reported under U.S. GAAP to assist the reader in better understanding our operational performance.
We have included the following table of consolidated adjusted sales and operating income for 2004. We believe that the adjusted amounts may be of assistance in comparing our operating performance between 2004 and 2005. However, adjusted financial information should not be viewed as a substitute for measures of performance calculated in accordance with U.S. GAAP. The consolidated adjusted amounts reflect the following adjustments:
1. the inclusion in the adjusted amounts of the consolidated results of Cole for the full year 2004; and
2. the elimination of wholesale sales to Cole from Luxottica Group entities for the full year 2004.
This information is being provided for comparison purposes only and does not purport to be indicative of the actual results that would have been achieved had the Cole acquisition been completed as of January 1, 2004.
The following table reflects the Companys consolidated net sales and income from operations for 2004 as reported and as adjusted:
The following table summarizes the combined effect on consolidated net sales of exchange rates and the Cole acquisition, to allow a comparison of net sales on a consistent basis:
The 8.8 percent increase in net sales on a consistent basis in 2005 as compared to 2004, as adjusted, is mainly attributable to the additional sales of our Ray-Ban product lines, as well as to the additional sales of the Prada, Versace and Bulgari product lines and increased comp store sales (as previously defined) of our retail division.
The following table summarizes the effect on consolidated income from operations of the Cole acquisition to allow a comparison of operating performance on a consistent basis:
On a consolidated adjusted basis, including Coles results for 2004, income from operations in 2005 would have increased by 25.0 percent and operating margin would have increased to 13.8 percent from 12.0 percent as compared to 2004.
Comparison of the year ended December 31, 2004 to the year ended December 31, 2003
Net Sales. Net sales increased 14.1 percent to Euro 3,255.3 million during 2004 as compared to Euro 2,852.2 million for 2003.
Net sales in the retail segment, through LensCrafters, Sunglass Hut, OPSM and the newly acquired Cole, increased by 15.7 percent to Euro 2,346.7 million for 2004 from Euro 2,028.2 million for 2003. This increase was primarily due to the inclusion of Cole sales from the date of acquisition on October 4, 2004, which amounted to Euro 240.5 million, as well as the inclusion of OPSM sales for an additional seven months in 2004, which amounted to Euro 172.5 million. In addition to such increases, retail sales in North America increased due to a higher average sales price per customer transaction resulting from an increase in the sale of premium products, partially offset by the weakening of the U.S. dollar against the Euro. The effect of the weakening of the U.S. dollar on 2004 retail sales in North America was approximately Euro 204.8 million. As the U.S. dollar continues to weaken in the period subsequent to the year ended December 31, 2004 we will continue to suffer a negative effect on net sales.
Net sales to third parties in the manufacturing and wholesale segment increased by 10.3 percent to Euro 908.6 million for 2004 as compared to Euro 824.0 million in 2003. This increase was mainly attributable to increased sales of our Ray-Ban brand and the new Prada and Versace product lines, which sales began after the first quarter of 2003 and have almost completely offset the loss of sales of Giorgio Armani licensed products due to the cancellation of the license agreement with Armani in 2003. Management believes that by 2005 the new licenses will have more than offset the sales lost due to the cancellation of the Armani license agreement. We do not believe that the termination of the license agreement with Armani will have a material adverse effect on our results of operations for future periods. These increases were partially offset by the weakening of the U.S. dollar which represents approximately 15% of this segments net sales for fiscal 2004. The effect of the weakening of the U.S. dollar on wholesale and manufacturing sales to third parties in 2004 was approximately Euro 12.7 million.
On a geographic basis net of intercompany transactions, operations in North America resulted in net sales of Euro 2,083.5 million during 2004, comprising 64.0 percent of total net sales, an increase of Euro 134.1 million from 2003. This increase was primarily due to the inclusion of Cole sales from the date of acquisition on October 4, 2004, which amounted to Euro 240.5 million, partially offset by the weakening of the U.S. dollar against the Euro. Net sales for operations in Asia Pacific, which consists of Australia, New Zealand, Singapore, Malaysia, Hong Kong, Thailand, China, Japan and Taiwan, were Euro 435.1 million during 2004, comprising 13.4 percent of total net sales, an increase of Euro 181.3 million as compared to 2003. This increase was mainly attributable to the inclusion of OPSM sales for an additional seven months in 2004. Net sales for the rest of the world accounted for the remaining Euro 736.7 million of net sales during 2004, which represented a 13.5 percent increase as compared to 2003. The increase in the rest of the world is mostly attributable to higher sales in the European and Latin American regions.
During 2004, net sales in the retail segment accounted for approximately 72.1 percent of total net sales, as compared to approximately 71.1 percent of total net sales in 2003 due to the two retail acquisitions previously mentioned.
Cost of Sales. Cost of sales increased by 15.2 percent to Euro 1,040.7 million in 2004 from Euro 903.6 million in 2003. Cost of sales in the retail segment increased by Euro 103.4 million, which increase is primarily attributable to the inclusion of Cole in our results of operations from the date of acquisition and to the inclusion of OPSM in our results of operations for an additional seven months in 2004. Cost of sales in the manufacturing and wholesale segment increased by Euro 32.5 million due to the increase in net sales. As a percentage of net sales, cost of sales increased to 32.0 percent from 31.7 percent. Manufacturing labor costs increased by 6.6 percent to Euro 256.9 million in 2004 from Euro 240.9 million in 2003. This increase is attributable to the increase in net sales. As a percentage of net sales, cost of labor decreased to 7.9 percent in the year 2004 from 8.4 percent in 2003, due to the inclusion of Cole results, since Coles cost of labor as a percentage of sales is lower than the rest of the Group. For 2004, the average number of frames produced daily in our facilities (including Tristar, our Chinese factory) was approximately 123,000, which was in line with 2003 production.
Gross Profit. For the reasons outlined above, gross profit increased by 13.7 percent to Euro 2,214.6 million in 2004, from Euro 1,948.6 million in 2003. As a percentage of net sales, gross profit decreased to 68.0 percent in 2004 from 68.3 percent in 2003 for the reasons as previously discussed.
Operating Expenses. Total operating expenses increased by 13.5 percent to Euro 1,721.8 million in 2004 from Euro 1,516.8 million in 2003. As a percentage of net sales, operating expenses decreased to 52.9 percent in 2004 from 53.2 percent in 2003.
Selling and advertising expenses, including royalty payments, increased by 11.4 percent to Euro 1,376.5 million during 2004 from Euro 1,235.8 million in 2003. Euro 88.0 million of this increase is attributable to the inclusion of OPSM in our results of operations for the first seven months of 2004. Euro 110.2 million of this increase is attributable to the inclusion of Cole to our results of operations in the fourth quarter of 2004 (from the date of acquisition). These increases were offset by the weakening of the U.S. dollar, which decreased U.S. selling and advertising expenses by Euro 97.9 million. As a percentage of net sales, selling and advertising expenses decreased to 42.3 percent in 2004 from 43.3 percent in 2003. This decrease as a percentage of sales is primarily attributable to the increase in sales in the North American retail division without a corresponding increase in these costs based on the fixed cost sales structure of the retail operations.
General and administrative expenses, including intangible asset amortization, increased by 22.8 percent to Euro 345.2 million in 2004 from Euro 281.0 million in 2003. Euro 28.4 million of this increase is attributable to the inclusion of OPSM and the amortization of its trade names in our results of operations for the first seven months of 2004, while Euro 24.9 million is attributable to the inclusion of Cole. This increase was offset by the weakening of the U.S. dollar, which decreased U.S. general and administrative expenses by Euro 17.6 million. As a percentage of net sales, general and administrative expenses increased to 10.6 percent in 2004 from 9.8 percent in 2003. This increase was primarily due to the consolidation of OPSMs results in our results of operations. As we continue the integration of OPSM, we expect its operating expenses as a percentage of sales to decrease due to the expected higher efficiency in the fixed cost structure. In addition, the restructuring of the Cole operations is underway and it is expected that the general and administrative costs of Cole will diminish during 2005.
Income from Operations. Income from operations for 2004 increased by 14.1 percent to Euro 492.8 million from Euro 431.8 million in 2003. As a percentage of net sales, income from operations remained constant at 15.1 percent for both 2004 and 2003.
Operating margin, calculated as income from operations divided by net sales, in the manufacturing and wholesale distribution segment increased to 21.3 percent in 2004 from 19.2 percent in 2003. This increase in operating margin is attributable to higher efficiency in our fixed cost structure driven by increases in net sales.
Operating margin in the retail segment decreased to 13.2 percent in 2004 from 13.3 percent in 2003. This is a result of the consolidation of Cole results, whose operating margin is lower than that of our other retail chains. However, we believe that when the final restructuring of the North American Retail Division is completed, we will return to our historical operating margins by the end of 2006.
Other Income (Expense)-Net. Other income (expense)-net was Euro 35.7 million in 2004 as compared to Euro 42.0 million in 2003. This decrease in other income (expense)-net is mainly attributable to an increase in other income-net of Euro 13.4 million attributable to higher realized and unrealized foreign exchange gains on certain transactions. With the acquisition of Cole, as discussed earlier, and a trend in rising interest rates, we expect a significant increase in interest expense for 2005.
Net Income. Income before taxes increased by 17.3 percent to Euro 457.2 million in 2004 from Euro 389.8 million in 2003 due to our increase in sales, which includes Cole sales for the last three months of 2004, while maintaining our gross profit margins and keeping our operating expenses constant as a percentage of sales. As a percentage of net sales, income before taxes increased to 14.0 percent in 2004 from 13.7 percent in 2003. Minority interest increased to Euro (8.6) million in 2004 from Euro (5.1) million in 2003. With our previously announced acquisition of the remaining shares of OPSM, we expect our minority interest to decrease in future periods. Our effective tax rate was 35.4 percent in 2004, while it was 30.1 percent in 2003. The effective tax rate is estimated to be between 37 to 40 percent in 2005 as we ended our permanent benefits from subsidiaries losses. Net income increased by 7.3 percent to Euro 286.9 million in 2004 from Euro 267.3 million in 2003. Net income as a percentage of net sales decreased to 8.8 percent in 2004 from 9.4 percent in 2003.
Basic earnings per share for 2004 were Euro 0.64, increasing from Euro 0.60 for 2003. Diluted earnings per share for 2004 were Euro 0.64, increasing from Euro 0.59 for 2003.
Non-GAAP Financial Measures
We use certain measures of financial performance that: (i) exclude the impact of fluctuations in currency exchange rates in the translation of operating results into Euro; (ii) include the results of operations of OPSM for the entire year ended December 31, 2003; (iii) include the results of operations of Cole for the three-month period ended December 31, 2003; and (iv) adjust for the fact that the North American retail calendar in 2003 included 53 weeks while fiscal 2004 was a 52-week year. We believe that these adjusted financial measures provide useful information to both management and investors by allowing a comparison of operating performance on a consistent basis. In addition, since we have historically reported such adjusted financial measures to the investment community, we believe that their inclusion provides consistency in our financial reporting. Further, these adjusted financial measures are some of the primary indicators that management uses for planning and forecasting in future periods. Operating measures that assume constant exchange rates between 2004 and 2003 are calculated using, for each currency, the average exchange rate for the year ended December 31, 2003.
Operating measures that exclude the impact of fluctuation in currency exchange rates are not measures of performance under U.S. GAAP. These non-U.S. GAAP measures are not meant to be considered in isolation or as a substitute for results prepared in accordance with U.S. GAAP. In addition, our method of calculating operating performance to exclude the impact of changes in exchange rates may differ from methods used by other companies. See the table below for a reconciliation of the operating measures excluding the impact of fluctuations in currency exchange rates to their most directly comparable U.S. GAAP financial measures. The adjusted financial measures should be used as a supplement to results reported under U.S. GAAP to assist the reader in better understanding our operational performance.
We have included the following table of consolidated adjusted sales and operating income for 2003. We believe that the adjusted amounts may be of assistance in comparing our operating performance between 2003 and 2004. However, adjusted financial information should not be viewed as a substitute for measures of performance calculated in accordance with U.S. GAAP. The consolidated adjusted amounts reflect the following adjustments:
1. the inclusion in the adjusted amounts of the consolidated results of OPSM for the seven-month period ended July 31, 2003, prior to the acquisition;
2. the elimination of wholesale sales to OPSM from Luxottica Group entities for the seven-month period ended July 31, 2003;
3. the inclusion in the adjusted amounts of the consolidated results of Cole for the last three months of 2003;
4. the elimination of wholesale sales to Cole from Luxottica Group entities for the last three months of 2003; and
5. the elimination of the effect of the 53rd week on 2003.
This information is being provided for comparison purposes only and does not purport to be indicative of the actual results that would have been achieved had the OPSM acquisition been completed as of January 1, 2003 and the Cole National acquisition been completed as of October 4, 2003.
The following table reflects the Companys consolidated net sales and income from operations for 2003 as reported and as adjusted:
The following table summarizes the combined effect on consolidated net sales of exchange rates, the OPSM and Cole acquisitions and the elimination of the effect of the 53rd week in 2003 to allow a comparison of net sales on a consistent basis:
(1) U.S. $ 41.7 million converted in Euro at the fiscal year 2003 average exchange rate (calculated using the noon buying rates) of Euro 1.00=U.S. $1.1307.
At constant exchange rates between the periods, net sales would have increased by 21.6 percent during 2004 as compared to 2003. The 6.9 percent increase in net sales on a consistent basis in 2004 as compared to 2003 is mainly attributable to the additional sales of our Ray-Ban brand and the new Prada and Versace product lines, which sales began after the first quarter of 2003, and the increased sales of our retail division, as previously discussed.
The following table summarizes the effect on consolidated income from operations of the OPSM acquisition, the Cole acquisition and the elimination of the effect of the 53rd week in 2003 to allow a comparison of operating performance on a consistent basis:
(2) U.S. $10.9 million converted at the fiscal year 2003 average exchange rate (calculated using the noon buying rates) of Euro 1.00=U.S. $1.1307.
On a consolidated adjusted basis, including OPSMs and Coles results for 2003 and eliminating the effect of the 53rd week in 2003, income from operations in 2004 would have increased by 12.7 percent as compared to 2003. The 12.7 percent increase is attributable to an increase in the U.S. retail business partially offset by the weakening of the U.S. dollar, which was previously discussed.
Our effective tax rates for the years ended December 31, 2003, 2004 and 2005 were approximately 30.1 percent, 35.4 percent and 37.0 percent, respectively. The 2003 and 2004 effective tax rates were less than the statutory tax rate due to permanent differences between our income for financial reporting and tax purposes which reflect the net loss carryforward caused by the prior funding of subsidiary losses through capital contributions that are deductible for income tax purposes under Italian law, and the reduction in certain investments in subsidiaries. Such subsidiary losses were primarily attributable to the amortization of certain intangible assets associated with our acquisitions. This remaining net loss carryforward was completely utilized in 2004. For fiscal 2005 we received a net permanent benefit caused by the Company complying with an Italian law that allows for the step up in tax basis of certain intangible assets for which this benefit offset the aggregate effect of different rates in foreign jurisdictions.
Liquidity and Capital Resources
Our Cash Flows
Operating Activities. Our cash provided by operating activities was Euro 623.5 million for 2005 as compared to Euro 528.7 million for 2004 and Euro 327.5 million for 2003. The Euro 94.8 million increase in 2005 compared to 2004 is primarily attributable to an increase in net income, as previously discussed, and an increase in depreciation and amortization for 2005 resulting from the additional depreciation and amortization of Cole including Euro 17.3 million relating to the amortization of its intangible assets. The increase in cash provided by operating activities of Euro 201.2 million from 2003 to 2004 is primarily attributable an increase in net income, as previously discussed, and an increase in depreciation and amortization for 2004 resulting from the additional depreciation and amortization of the assets of OPSM, including Euro 5.8 million relating to the amortization of its trade name, and the amortization and depreciation of the assets of Cole including Euro 4.3 million relating to the amortization of its intangible assets. Accounts receivable was a use of cash in 2005 of Euro (33.3) million as compared to a use of cash in 2004 of Euro 15.8 million. This increase in cash flows from accounts receivable is primarily due to the increase in sales and the corresponding increase in our manufacturing and wholesale segment outstanding receivable balances. Prepaid expenses and other was a source of cash of Euro 21.1 million in 2004, as compared to a use of cash in 2003 and 2005 of Euro 43.6 million and Euro 56.8 million, respectively. This change was attributable to advance payments of Euro 31.5 million made in 2003 and Euro 30.0 million made in 2005 by us to certain of our licensors and the timing of certain tax payments by foreign subsidiaries. The amount of cash provided in 2004 by operating activities for inventory increased by Euro 20.5 million in 2005 compared to an increase of Euro 27.0 million in 2004 compared to 2003. This change in cash flow from inventory is primarily due to an increase in the inventory turns. Accounts payable and accrued expenses were a net source of cash of Euro 38.2 million in 2005 compared to a use of Euro 15.3 million in 2004 and a use of Euro 84.9 million in 2003. These improvements in cash flows from accounts payable and accrued expenses were caused by the timing of payments to certain vendors by the manufacturing and wholesale segment and by the North American retail division as well as the settlement in 2003 of certain liabilities of businesses acquired. Income tax payable was a source of cash in 2005 of Euro 124.0 million as compared to a use of cash in 2004 of Euro 0.8 million, mostly attributable to the adoption of the Italian tax law which allows for the step-up in tax basis of certain intangible assets and requires the accrual of current taxes to be paid in cash during fiscal 2006.
Investing Activities. Our cash used in investing activities was Euro 175.8 million in 2005. Cash used in investing activities consisted primarily of capital expenditures made to purchase fixed assets which included construction costs to expand our new North American Retail headquarters in Mason, Ohio and the acquisition of the remaining minority stake in OPSM offset by the sale of our investment in Pearle Europe. In 2004, our cash used in investing activities was Euro 480.5 million primarily attributable to the Cole National acquisition, for an aggregate amount, net of cash acquired and including direct acquisition-related expenses, of Euro 363.0 million. In 2003, our cash used in investing activities was Euro 468.6 million, primarily due to the acquisitions of I.C. Optics, E.I.D. and 82.57 percent of OPSMs ordinary shares and all of OPSMs options and performance rights, for an aggregate amount of Euro 342.4 million. The Euro 11.9 million increase is also attributable to an increase in