Novartis with a Spin: Alcon (In Three Parts)

Part I-Conclusion and Valuation of Novartis & Alcon

Disclaimer: There are still many uncertainties surrounding the share price, shares outstanding, among other factors of Alcon, as the spin-off’s information is yet to be finalized. The following report is meant as a preliminary and will be subject to change in the future.

Business Overview

Alcon is the global market leader in eye care with #1 and #2 positions in surgical and vision care in every region around the world. The company researches, discovers, develops, manufactures, distributes, and sells eye care products. The Alcon Division is the global leader in eye care, with product offerings in eye care devices and vision care. The Alcon Division is organized globally in two global business franchises as follows: Surgical and Vision Care. In Surgical, Alcon develops, manufactures, distributes, and sells ophthalmic surgical equipment, instruments, disposable products and intraocular lenses. In short, the division sells implants and equipment for procedures to treat cataracts and other eye disorders. In Vision Care, Alcon develops, manufactures, distributes, and sells contact lenses and lens care products.

Conclusion
Alcon is a special situation. It’s a spin-off undergoing a turnaround. Alcon will be spun-off from Novartis in the first quarter of 2019. This thesis advocates buying Novartis for when Alcon shares are distributed to Novartis shareholders.

First of all, the decision is great for Novartis, and ultimately for Alcon
The reason for the spin-off is simple: Novartis has struggled to make progress at Alcon since acquiring it in 2010 from Nestle. Net sales have either declined or stagnated for years. In short, Novartis is shedding a rather sluggish performer. The company (Novartis) would rather concentrate on gene-therapy and cancer ophthalmology after the AveXis acquisition so that it can make up for its dearth of market-approved immune-oncology drugs compared to rivals Roche, Merck, and Bristol-Myers Squibb. From the chart below, Alcon’s CAGR for operating income is a painful -9.7%!


Theoretically, current Shareholders get Novartis for a discount
When you buy Novartis, and Alcon shares are distributed to you, they are done at no extra cost. So, the value of your shares is the price of one Novartis share minus the price of the Alcon share (given the ratio was 1:1), which means you get Novartis at some discount. The only downside is that you may end up buying additional shares of Alcon (which will come at some additional cost) to average down during the first year due to forced selling. Since pension funds, index funds, insurance companies, and mutual funds are among the first to be awarded shares in the initial distribution, a portfolio manager at some fund may decide that the spinoff doesn’t meet the portfolio’s investment criteria and then must be sold off. Selling pressure will usually last the first year, and the spin-off may see a betterment of performance beginning in the second year.

Lastly, the spinoff is a tax-neutral distribution for Swiss and US federal income tax purposes

At first glance, Alcon has a bit of an ick! factor. Sluggish performer? Check. Novartis doesn’t want it? Check. Reason for stagnation, and decline? It’s got some things going against it. To name a few, it faces competition and pricing pressure from generics. An article stated that “ competition from new foreign manufacturing expanding into Europe are severely undercutting prices in order to gain market share” and that “lower pricing and reduction in market share has resulted in an overall adjustment in product average selling prices (ASPs)” which in itself is a self-fulfilling prophecy through a feedback loop of lower prices lowering market share.

Alcon also faces competition from established players like Abbott Optics and Bausch & Lomb. Look at the sales growth numbers for Abbott Optics at J&J. There is clear growth there. Abbott Optics has already overtaken Alcon for #1 place in contact lenses. From an article, “Novartis invested heavily in direct to consumer advertising a few years back to boost its contact lenses business which was struggling to stand out in a market dominated by Bausch & Lomb, CooperVision, and J&J’s Vision Care…[that performance has not yet materialized.]” Alcon’s eye drugs unit was absorbed back into Novartis last year, leaving the company with a surgical equipment and contact lens operations valued at approximately $20.5B. Alcon’s performance was impaired by a decline in their surgical equipment sales in both the US and emerging markets, as well as increased competition from generics for some eye treatments.

Check. Check. Check…

So, what does Alcon have going for it? Two words: Reversible Decline.

When most of Alcon’s competitors are growing and making reasonable returns, while Alcon isn’t, it may be reasonable to conclude that the decline is the result of poor choices made by the parent (Novartis), and that new management could turn the company around. The turnaround is more possible if Alcon can benefit from changing macro trends.

Key drivers include favorable demographic trends with an increasingly aging population, coupled with an increasing access to eye care.

The aging populations of the world’s developed economies (the baby boomers) turned 60 in 2007. Since then, they had entered into a phase in life where eye-related problems are much more likely. As people get older, their eyes are prone to a number of diseases like cataracts, glaucoma, and age-related macular degeneration. Because people live longer, there will inevitably be an increase in the number of people who experience eye disease and visual dysfunction which will fuel the market for eye care products.

Alcon is also a first-line beneficiary of increasing spending on health care (as national incomes in developed countries continue to rise), because it is highly-cost effective to treat many eye-related diseases to maintain people’s independence. There is still an untapped market in emerging markets for cataract surgery, which presents a major opportunity for the company.

The surgical division benefits from innovation and aging demographic trends to the point that it is not affected by economic conditions. This includes product lines related to cataracts and vitreoretinal treatments. On the other hand, products for refractive treatments (i.e. LASIK) are particularly sensitive to declines in consumer spending. Currently, about 30% of Americans skip or delay medical treatments due to high costs. The solution is that increased coverage and reimbursement opportunities from government and private insurance can lead to expanding patient access to eye care products.

Lastly, Alcon has the opportunity for margin expansion. While its earnings power may be hidden, cash flows tell the real story. The details on this are discussed in the Valuation section below.

Valuation


First and foremost, you should establish what the intrinsic value of owning Novartis is. What follows is an EVA analysis that assumes the spin-off provides no benefits whatsoever to the company, and Novartis continues to stagnate in NOPAT and decline in its capital trend.





This is a rather bleak and very conservative estimate. Assuming that capital declines at a rate of 30% per year, and discounting out three years (t=3), while assuming a discount rate of 10%, the intrinsic value comes out to $82.04. This estimate is less than the company currently trades. However, the valuation does not take into account the value of shadow divisions. Having minority stakes in peers can allow Novartis to benefit from the success of a second pharma. Novartis currently holds a 33.3% stake in Roche, and previously held another in GlaxoSmithKline (36.5%, consumer healthcare JV). There are two benefits. The first is that the company presents receives income from its investment in Roche (approx. $445M per annum). The second is that the investment will eventually be bought out by Roche. The precedent was set when GlaxoSmithKline bought back the stake from Novartis last year for $13B. The market value for the Roche investment is $13.4B. Assuming it was sold, this would add $15.55 of intrinsic value to the share price, resulting in a total value of $97.59.


Given that intrinsic value exists in a range, I decided to use break-up valuation as a cross-reference.






I assumed a risk-free rate of 2.7% and a risk premium of 3.22%. From this analysis, I can obtain the intrinsic value of Novartis’s shares post-spinoff. If we assume that EBIT will rebound to 2014 levels, then the intrinsic value per share is $98, giving an upside of 14%. This is roughly the same value as the EVA analysis.


Next, we have to value Alcon. Alcon before the Novartis acquisition was much different than the Alcon that exists today. The Alcon of yore experienced impressive CAGR: 11% for sales, 14% for operating income, and 17% for earnings. The average ROE, ROA, and ROIC was 34%, 26%, and 27%. As such, I thought it was best to value it via a simple EPV approach, as I believed that large net cash position had as much value as the earnings it produced each year (on average, the net profit margin was 29%!). The valuation below doesn’t have to worry about margin expansion (earnings matched FCF), because margins were stable, despite being very far above average.



Alcon today is much different, and as such, needs to be valued very differently. Looking at operating income, the company appears to become worse each year. Earnings are well below FCF ($200-300K vs. $800-900K). Profit margins are 4-5%, a shadow of where they used to be. In reality, earnings power is hidden by excessive amortization charges and discrepancies between income taxes and reported taxes.




When margins regress to where the charges have been normalized, Alcon should return to a stable range between 11% and 13%. If assigning a PE multiple of 7 (assuming no growth), then the market cap should be $5.8B (assuming shares outstanding of 300M), giving a per share price of $19.35. If assign a PE of 11, then the market cap should be $9.1B, giving a per share price of $30.41. Given that the consensus values Alcon around $15-$30B, I estimate that there will be downward revisions during the shareholder vote in February (unless, of course, shares outstanding is increased).


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