Description

I'm long the shares of Alcon (ALC SW or ALC US).  Alcon is a recent ophthalmology medtech spin-off from Novartis.  Alcon is exposed to favorable long-term demand trends and has attractive qualitative characteristics in its business model and market that should eventually translate to good sustainable mid-cycle EBIT growth with a high degree of probability.   

Brief business description

Alcon has a long history, having originally been started in 1945 and spending a couple of decades under full or partial ownership of Nestle and Novartis. Novartis acquired the business from Nestle for $52B in 2010, before eventually deciding to focus entirely on pharma and spinning it off in 2019.   Alcon is the leader in the ophthalmic market globally, with a >30% market share. Alcon consists of two distinct business segments: 

Surgical (includes equipment for surgeries and diagnostics, implantable contact lenses for cataracts, and consumables for eye surgeons) and Vision Care (consumer contact lens, liquid solutions and eye drops). Each of the two business lines / markets has a MSD % sales CAGR trend. In each of the two business lines / markets, Alcon has a #1 or #2 market position.   Alcon has a particularly strong shares in the vitreoretinal and cataract segments of the Surgical market.  The market has oligopolistic tendencies, with substantial barriers to entry and barriers to scale in the form of years of cumulative R&D and FDA approvals, and substantial sales and marketing budgets needed to reach the fragmented base of ophthalmologists and opticians.  

Key competitors in Surgical include JNJ, Carl Zeiss, and Bausch & Lomb (B&L). JNJ is present across all of ophthalmology and is a strong rival to Alcon.  Carl Zeiss is traditionally strong in diagnostic equipment and equipment for refractive / laser surgery, and is attempting to use that as a beachhead to expand into cataract and vitreoretinal surgical equipment, consumables and implantables.  B&L has a relatively broad portfolio in Surgical but is considered a relatively distant, sub-scale competitor.  In Vision Care, JNJ, and Cooper are the strongest competitors, and B&L also has a presence. 

The business is led by CEO David Endicott; like Endicott, most of the top management team are ex-Pfizer/Hospira.  Endicott strikes me as a straightforward, capable operator.  Endicott and most of the management team are based in Texas.

Business model

Alcon in reality is a sum of two different businesses (Surgical and Vision Care) and it makes sense to analyze them separately. 

Surgical: implantables (i.e. lenses for cataracts), consumables (surgical packs used by eye surgeons for cataract and other surgeries), and equipment / other (surgery & diagnostic equipment for eye surgeons). For Alcon, this segment does have some products that cover refractive (e.g. laser eye surgeries), but overall the segment is highly focused on cataract surgeries (AKA phacoemulsification or phaco) and retinal surgeries. The typical age of the patient is significant i.e. well over 60.  Alcon’s process of selling its products to the surgeon / medical professional has similarities to the classic medtech sales approach.   There is a direct sales force that seeks to "educate" (i.e. sell to) ophthalmologists (i.e. the eye surgeons) and wherever ophthalmologists work, e.g. hospitals and ambulatory surgery centres (ASCs); this is augmented with a presence in / sponsorship of medical conferences and articles in medical journals. There is some degree of loyalty and habit among surgeons and medical professionals.  An average ophthalmologist that sees patients has many years of experience under his/her belt, starting with medical school and residency, and tends to get used to specific brands of surgical equipment.  However, this loyalty / habit effect shouldn’t be overstated. Ophthalmologists / ophthalmology centres can be very cost-conscious and bargain hard against equipment vendors such as Alcon and JNJ to get the best possible deal.  Often Alcon or JNJ can give the equipment away almost for free, making money on the associated surgical consumables.  The interpersonal aspect is also important, i.e. whether or not the ophthalmologist likes the Alcon sales rep more than they like the JNJ sales rep can determine the sale.    Similarly to the habit formation for equipment, some ophthalmologists tend to get used to recommending, selling and then fitting specific brands of implantable ocular lenses (IOLs) for cataracts and will not begin to favor other brands unless they see sufficiently big reasons such as a step-up in performance.   Alcon and JNJ are trying hard to create as much of a ‘closed loop’ ecosystem to encourage product stickiness and demand recurrence.   For instance, Alcon’s products are designed such that it is easier to use them if you have other Alcon products, e.g. Alcon’s consumables and IOLs are more convenient to use for the surgeon if the surgeon already has Alcon surgical equipment. 

The sales process from the ophthalmologist to the end customer (the patient) varies depending on the pathology and the local market (i.e. the reimbursement system).  Usually, the process goes like this.  An ophthalmologist examines a patient and determines that the patient has cataracts (something that the patient, being of a certain age, probably already suspected) and then encourages the patient to get a cataract surgery.  A surgeon can do as many as 30 cataract surgeries per day and the length of the surgery can be as quick as 15 minutes.  In the US, Medicare will cover the cost of the surgery as well as the cost of the basic implantable cataract lens (IOL) of the ‘monofocal’ variety.  A monofocal lens will result in some improvement of vision, but more expensive and technically advanced lenses could do an even better job - EDOF (extended depth of field) lenses, trifocal lenses, and multifocal lenses.  The ophthalmologist will inform the patient that if the patient is willing to pay more and opt for a more advanced lens, the patient could improve their vision along several parameters, but with some trade-offs.  As of now, there are no ‘perfect’ IOLs for cataracts in existence.   I.e. there is no one type or brand of cataract lens that gives perfect vision in near, medium and long distances, has very resilient material, and gives no visual aberrations (like halo, starburst, glare).  There are always trade-offs.  I.e. if you want very good near vision (a feature of multifocal lenses), you might get glares & halos.   Both Alcon and JNJ offer a range of cataract lenses that are strong in some areas but not strong in the others.  Alcon and JNJ have the strongest lineups but no player is perfect.  JNJ’s lenses generally don’t give good near reading range (i.e. you might still need glasses to read small texts or look at your phone, also known as poor degree of ‘spectacle independence’), “rotate” in the eye (which means the surgeon might have to fix them up occasionally), but they have the advantage of not having halos and glare, and surgeons tend to really like JNJ’s material.   Alcon’s new lenses (PANOPTIX,) are excellent for near-range but can give some halos and glares, especially at night (and as a result, ophthalmologists can shy away from recommending them to patients who do lots of night-time driving); Alcon’s lenses are also made of more delicate material and are more fiddly to install.   Therefore, because no one lens is “perfect”, sometimes surgeons compromise by offering the patient “blended vision”, i.e. putting one type of cataract lens in one eye and another type in a different eye. The surgeon can put a specific type of Alcon lens in the patient’s left eye and a JNJ lens in the right eye, for instance. 

JNJ and Alcon generally don’t compete on price in cataract IOLs.  There are multiple factors that determine whether a cataract surgeon gravitates to Alcon vs JNJ (or any other vendor, e.g. B&L).  The surgeon’s relationship with the Alcon or JNJ salesperson is important.  It helps if the surgeon likes the salesperson.  Often, Alcon / JNJ will have a ‘bundle’ arrangement with the surgeon or the surgeon’s clinic whereby Alcon / JNJ will give some equipment for a very low price but the surgeon then commits to Alcon / JNJ lenses and consumables.  This effectively “locks out” competing manufacturers for some period of time.   But beside that, there’s not much loyalty to a particular brand.  If a surgeon has been using mainly Alcon lenses for a long period of time but a very superior JNJ lens comes out to the market, then the surgeon will switch.   The way I see it, the way JNJ and Alcon compete with each other is a bit similar to Airbus and Boeing, i.e. both have ‘roadmaps’ of when they plan to introduce certain products to take white-space and to avoid cannibalizing their own earlier products.   Alcon is currently enjoying a period of strong market share gains in the US market for cataract IOLs thanks to successful launch of PANOPTIX multifocals.   Alcon probably decided 2019-2021 are “the PANOPTIX years”, and JNJ decided they’ll launch new Symfony products in 2020-2022. At the same time, Alcon will actively focus on selling VIVITY (a ‘non-diffractive’ EDOF IOL) only in 2021/22-2023, after the PANOPTIX sales push has largely taken place, so as to avoid VIVITY cannibalizing on PANOPTIX.  There are some obvious ways that PANOPTIX could be improved (i.e. switch to better material) but Alcon is probably not in a rush to do that, so as to maximize the overall long-term revenue opportunity.

In the US, monofocal IOLs sell for $150 per eye whereas more advanced lenses like trifocals, multifocals and EDOFs can cost a patient as much as $1500 per eye; more advanced lenses are higher-margin for the manufacturer (Alcon & JNJ) and are also more lucrative to the ophthalmologist and ophthalmologist’s place of work (because the patient pays a mark-up to whatever the ophthalmologist’s practice pays to Alcon & JNJ).   There is thus a strong incentive for Alcon to encourage as much lens “premiumization” as possible, but this is balanced against affordability (lots of patients may simply not have the savings or disposable income to pay that much) and ophthalmologist’s Hippocratic Oath and duty of care - some patient’s condition of the eye may mean that a basic monofocal lens may be a better solution and advanced lenses might not be recommended.  Patients that do better with monofocals include those with severe glaucoma and corneal decomposition.   Overall, there is no consensus among surgeons on the speed and overall LT opportunity for lens ‘premiumization’, but anecdotally 80-90% of cataract surgery volumes in the US and Europe involve basic monofocals.  This suggests lots of long-term room for greater 'premiumization'.

Note that cataract-focused products are the biggest part of Alcon’s Surgical revenue and are also the focus of the discussion above, but Alcon also has a strong share in equipment for vitreoretinal surgeries (vitrectomies).  Vitrectomy surgeries are more complex and time consuming (can take as much as 90 minutes vs 15 minutes for a cataract surgery) and are required to address serious problems with the retina such as macular holes, diabetic retinopathy, and a detached retina.  

Overall, the Surgical piece of the ophthalmology business has the qualitative hallmarks of a good business.  It is a relatively concentrated, oligopolistic market with high barriers to entry and scale.  A successful player needs: (i) a big sales and marketing budget to interact with and educate the ophthalmological community; (ii) a big R&D budget to constantly support and advance multi-year projects from conception, study and all the way to approvals by regulators such as FDA; (iii) significant manufacturing capability; (iv) the accumulated brand equity and a big service organization that gives the ophthalmologist the confidence that you will properly service and support the purchased equipment during its useful life and will innovate and introduce improvements; and (v) ability to offer a “suite” or “portfolio” approach of products to address as many of the ophthalmologist’s needs and pathologies as possible. 

Vision Care: this segment consists of consumer products sold DTC, over the counter and via opticians, i.e. reusable and disposable contact lenses as well as eye drops and contact lens solutions. In contrast to the Surgical division, this division is almost entirely focused on refractive conditions (myopia / nearsightedness) as well as dry eye. Alcon's market position in Vision Care is somewhat weaker than in the Surgical space, and Vision Care is more competitive and more commoditized. JNJ is the world leader in soft contact lenses, and Alcon historically was preocuppied with fighting Cooper for the number 2 spot; Cooper today is stronger than Alcon in Vision Care, in my view. The fastest growing segment of the market are the disposable dailies; the reusable segment (and the associated liquids) is more challenged. Even though Vision Care has more intense competition than Surgical, Vision Care is still a briskly-growing market and Alcon is currently enjoying some good product momentum due to new product launches. Alcon's launches include daily disposable ‘toric’ lenses for astigmatism (DAILIES TOTAL1 TORIC) and a higher-performance general disposable lens (PRECISION1). 

The Vision Care segment has some specific dynamics to it.  When a glasses-wearer switches from glasses to a branded reusable lens, that is very accretive and beneficial for the lens manufacturer (i.e. Alcon, JNJ, Cooper or B&L). You could say that a new customer has been acquired.   However, if that consumer then eventually switches to a daily disposable lens, that transition has a mixed economic impact on the lens manufacturer.  The monthly and weekly revenue from that consumer drops.  That consumer will also no longer generate the associated revenue from contact lens solutions / liquids.  The manufacturer will generate the same dollar gross profit from that consumer only after a period of a few months, if the consumer keeps ordering daily lenses without fail.  And if the consumer eventually gets a LASIK/LASEK (laser refractive surgery on the eyes), then that consumer has ‘churned’ and is lost forever. 

Different geographies have different characteristics and habits among consumers.  In Europe and Japan, glasses are still widespread, but among those who wear contacts, many already have transitioned to daily disposables.  In the US, glasses-wearers aren’t as widespread but among the US contact wearers, a lower proportion have switched to daily disposables and are still favoring reusable lenses.

The manufacturing process for consumer contact lenses tends to be capital-intensive and deliver very lumpy profits and FCF dynamics when the manufacturer launches new product lines that utilize new technology.  For Alcon, the PRECISION1 daily SiHy (silicon hydrogel) contact lenses launched last year required significant capex and likely use different production technology than Alcon’s existing flagship daily SiHy product DAILIES TOTAL1.  

Favorable LT demand trends

There are a couple reasons why long-term, ophthalmology demand is expected to sustainably and predictably grow at significant rates.  The most important one is the ageing of the global population.  I estimate that every year, 60 million people globally turn 65 years of age, and the population of people aged 65 and over is growing by a CAGR of 2.9%.  The UN expects this age group to go from 693 million in 2019 (9% of total population) to 1,552 million in 2050 (16% of projected 2050 population).  The increasing human longevity is testing the limits of a human eyeball.  A cataract is a symptom of the likely truth that the human eyeball was not designed to last for more than 70 years, and the eyeball’s ‘evolution’ has not kept pace with increasing life expectancy of a person.  There is a wide variety of cataract types.  Some can be deferred for as much as 20 years, but others are more debilitating and need to be addressed immediately.   It is estimated that 10 million cataract operations are performed globally each year.  Note that the 10 million figure is far lower than the 60 million that enter the ‘65 years and over’ age category each year; it's a reasonably safe assumption that the number of cataract surgeries will grow considerably for the foreseeable future.    There are various bottlenecks limiting its growth, including poor general awareness among the population and lack of appropriately trained and skilled surgeons in some developing / EM countries.   Overall, the volume growth of cataract surgeries along with the increased penetration of the higher-value, more advanced, non-monofocal IOLs should deliver a sustainable MSD % CAGR for Surgical ophthalmology products for the next decade or even longer.

In addition to ageing, there are other, inter-related factors that are beneficial for ophthalmic demand.   These include increasingly sedentary lifestyles and prevalence of diseases such as diabetes.   A person with diabetes is more likely to require cataract surgeries and also to develop problems with the retina (such as diabetic retinopathy) that require surgical intervention.   Also, sedentary lifestyles requiring an average person to stare at electronic screens for extended periods of time are linked to more myopia, especially among younger people.  There are forecasts projecting that more than half of the human population by 2050 will have some sort of myopia.  This should benefit the Vision Care segment of Alcon. Overall, the Vision Care market is also expected to grow by an MSD % CAGR for the foreseeable future.

Margin profile, valuation and Covid

Alcon’s financials are currently noisy and are burdened with various non-recurring costs (such as separation and transformation costs, including SAP / ERP costs) and non-GAAP adjustments (the biggest of which is an intangible amortization add-back) that stem from the Novartis spin.  Prior to covid, Alcon exhibited an adjusted EBIT margin in the high-teens %, with a goal of returning to a 23% margin in the medium term.  That goal is realistic because during Novartis’s ownership, adjusting for the disposal of the ophthalmic pharma business, Alcon achieved 22-26% EBIT margins in 2014/15.   Across peers, Cooper has a 25% GAAP EBIT margins in Vision Care and JNJ has 28% GAAP EBIT margins in MedTech (the division that includes JNJ’s ophthalmic surgical revenue); the JNJ comparison might not be completely attainable for Alcon because JNJ’s MedTech business is a lot bigger than Alcon's Surgical business and to get to JNJ-level margins, Alcon would have to grow a lot and unlock more operating leverage.  For now, the first milestone Alcon is focused on is to get to 23% adjusted EBIT margins around 2023/24, at which time Alcon should reach revenue greater than $9 billion and adjusted EBIT of $2B+ and adjusted EPS of c.$3.20.  Alcon is thus currently valued at 20x that future EPS.  In my view, at that time the arguments for demand growth runway and the oligopolistic structure of the Surgical market will remain as strong as today, and 20x P/E will be too low a valuation level for Alcon.  As a result, at current prices I see a solid prospect of generating a low-teens % equity IRR holding Alcon shares for the next 3-4 years as well as beyond that period.   As it relates to covid, the market has been remarkably good at ‘looking through’ covid and the Alcon share price is close to its all-time high level.  Alcon’s calendar 2020 (and probably calendar 1H 2021) will both be bad due to lower-than-normal patient flow (as well as lower Vision Care sales due to lower contact fittings and greater glasses-wearing as more people are working from home), but a strong argument can be made that this is deferred demand, not destroyed demand; cataracts and retinal pathologies cannot be put off forever and reticent patients will eventually return to the ophthalmologist’s surgery room as covid normalizes.  

Risks

Lumpiness: The revenue cycles in the ophthalmology industry are lumpy; revenue and EBIT will not move in a straight line.  When Alcon’s new product launches are scarce but competitors are launching many new products, Alcon’s growth and margins will disappoint while that of its competitors will impress.  Over longer time periods, however, this should normalize and the underlying secular demographic trends along with the reasonably oligopolistic industry structure should dominate.

Lockdowns: Alcon demonstrated that its operating results are far from immune against covid lockdowns.

Pharmacological innovations: To the extent that someone eventually invents effective medicines that eliminate or alleviate eye problems such as cataracts without the need for surgical intervention, companies like Alcon will suffer. 

Conclusion

If you look at Alcon's financial statements (as well as the current covid/lockdown-induced drop in results), you would not be able to immediately realize that Alcon is a solid medtech business operating in a market with lots of long-term growth runway. Many investors and some sell-side analysts are skeptical that Alcon can successfully make the jump from 'here' to 'there' (i.e. clean mid-20s % EBIT margin and steady MSD % / HSD % revenue growth), and in my view, that results in some undervaluation relative to Alcon's longer-term prospects. I believe Alcon can generate low-teens % IRR equity returns for extended periods of time.

Catalyst

Quarterly results

Passage of time

Cessation of covid lockdowns