Description

Advanced Medical Optics (AVO) competes in the vision care industry, providing products for ophthalmic surgical procedures and contact lens care products. The company was spun-off from Allergan (AGN) on July 1st and has traded down from $12.00 to a low of $7.70 since then.

The company generates over $500 mil in revenues a year, is the second largest player in its two industries, and receives roughly two-thirds of its revenue from international markets (total revenues: roughly one-third from Asia, one-third from Europe, and one-third from the U.S.)

Investment Thesis

The long investment thesis for AVO stems from the following:

Selling from AGN shareholders
Allergan is a biotech company with a potential super-blockbuster drug in Botox. It also is a member of the S&P 500. From AGN’s shareholders perspective, their high margin, high growth company was giving them shares in a no growth, low margin, high debt company. For most of the shareholders of AGN, selling AVO was a no-brainer. This artificial selling has forced AVO’s share price far below that of its intrinsic value (valuation discussed below).

Strong market positions
AVO’s ophthalmic surgical product line primarily focuses on the cataract and refractive markets. The company is the second largest company in the global cataract market, with a leading position in the European market. The company has also recently entered the rapidly growing LASIK market with what the company believes is a technologically advanced product that is currently being co-marketed by VISX.

The company also enjoys a strong position in the contact lens care market, with approximately 20% of the worldwide market. Moreover, the company believes it is the number one provider in the worldwide market outside of the United States, which is the growing segment of the market. Its Complete solution is also the fastest growing one-bottle solution in the world (according to the company), growing 30% in 2001.

Hidden earnings potential
This is the key factor regarding the AVO long thesis. A cursory glance of AVO’s historical financial statements reveals a company with a declining top line and a projected large increase in overhead expenses. However, a more detailed review offers some interesting facts:

1) The company is experiencing solid growth in its higher margin ophthalmic surgical product market. While overall sales have declined over the last two years (and the first quarter of this year), sales in the ophthalmic segment increased both years (and in the first quarter), thereby forcing margins higher. Also, on a constant currency basis, the growth of this segment has been much stronger than reported (see below).

2) Negative currency movements amplified recent top-line declines. With two-thirds of the company’s revenue coming from international markets, AVO’s financial performance is dependant upon exchange rates. For example, on a constant currency basis, AVO actually produced revenue growth in 2001. The recent dollar declines should allow AVO to report better than expected results.

3) Hidden strength in the contact lens care segment. While the company’s contact lens care segment has experienced declining revenue over the last 2 years, the company has experienced strong growth in its one-bottle care solution, Complete (as discussed above). As the market continues to move away from the multiple bottle to the one bottle solution, the company’s Complete product should continue to grow, and begin to more than make up for the company’s revenue decline in multiple bottle products. A reflection point appears to be near, as management has publicly stated it no longer sees a decline in revenues in the contact lens segment.

4) Possible unexpected earnings strength. As part of the spin-off, AVO is projecting an increase in SG&A expense of roughly $22 mil per year along with a slight increase in gross margin expense. Adding $22 mil in expenses to a company that reported pro forma 2001 earnings before taxes of $25.4 mil is quite a blow. However, with the recent accounting rule change halting the amortization of goodwill, AVO will in effect reduce expenses by roughly $10 mil. Combined with gross margin expansion (from the revenue mix shift), the $22 mil increase does not become as big of a factor as it originally appears to be.

Valuation:
Valuing AVO is somewhat difficult (hence the opportunity), as the company’s pro forma historical financial results do not accurately reflect its potential future results. Also, the company has no truly independent direct competitor. So, lets look at valuation 2 different ways:

1) Free cash flow
The company has publicly stated it is expecting FCF of $20-$25 mil for 2002. With a market value of $266 mil, that translates into a FCF yield of 7.5%-9.4%. Even if the company did not grow at all going forward (the company is expecting single digit top-line growth and double digit bottom-line growth over the next few years), I would consider that FCF yield high. (Also, the company has stated roughly $8 mil of cap ex for the year is expansion cap ex. So, if the company was not growing, the FCF yield would be even higher.) Using the same FCF estimate and a 5% yield, you get a stock price of roughly $14.00-$17.40.

2) EPS/EBITDA estimate and multiple
The one published report I have seen on AVO estimates the company will earn $.58 per share for 2002. I believe this number is low based on the following calculations:

EBITDA $73 to $75 (company estimates)
D&A 14 14 (4 times 1st quarter expenses)
Interest 26 26 (company projections)
EBT 33 35
Taxes 11.6 12.3 (35% tax rate)
Net 21.5 22.8
EPS 0.75 0.79 (28.7 mil shares outstanding)

My EPS calculations are obviously much higher than those of the one analyst. They are also higher than the one company estimate made months ago. (The company estimated EPS of $0.14 per AGN share – AGN shareholders received one share of AVO for every 4.5 AGN shares. So, the company’s estimate implied an EPS figure of $0.63 per AVO share.) However, I have reviewed these numbers numerous times and cannot arrive at a different conclusion given the company’s estimated 2002 EBITDA.

Based on my low estimate of $0.75 and using a P/E of 20 (somewhat arbitrary but not excessive given the company’s market position and estimated growth), you arrive at a stock price of roughly $15.00. For those of you still using EBITDA after all the bad press it has recently been subject to, a $15.00 share price would equate to 9.75 times an EBITDA of $75 mil. In my opinion, the multiples required to reach a $15.00 price are not excessive, and are supported by the FCF yield analysis above. Hence, I believe a stock price around $15.00 is nut unreasonable in the short term (especially if the company reports EPS numbers closer to $.75 than $.58).

Risks:
Specific company risks for AVO include:

Continued contact lens product revenue decline
As discussed above, AVO’s lens care product revenue should stabilize and even begin to grow going forward. If this segment faces increased erosion, AVO’s reported returns will obviously be negatively affected.

Unfruitful R&D expenditures
The company’s success in the ophthalmic market (and, to a certain extent, the contact lens care product) is dependent upon the improvement of current products and the introduction of new products. Because of this, the company has decided to increase research and development expense beyond its historical levels. If this investment bears no fruit, AVO’s competitors will inevitably cut into the market share of the company.

Significant debt levels
AVO was spun-off with roughly $275 mil in debt, resulting in expected interest expense of $26 mil per year. With expected EBITDA of around $75 mil, $26 mil in interest expense translates into less than 3 times interest coverage which is a little too leveraged for my taste. Of course, leverage works both ways, and any superior company performance would be amplified to the shareholders

Catalyst

The completion of selling from AGN shareholders and better than expected operating results.