Description

LONG: Carl Zeiss Meditec (AFX.GY)

Summary

Carl Zeiss Meditec (“CZM”), a producer of premium-grade ophthalmic and microsurgery devices, has an underappreciated monopoly position in next generation LASIK surgery (“SMILE”) equipment. The company is at the early stages of implementing a razor-and-blade model for SMILE, which will transform its earnings structure as an increasing mix of revenues will be derived from high margin consumables (primarily license fees). The company is also on the verge of introducing implantable multifocal intraocular lenses (“IOLs”) in key developed markets, targeting the large and growing cataract market. In its microsurgery segment, the company holds leading market shares in surgical microscopes for neurosurgery, ENT, reconstructive, dental, and spinal surgery.

We believe the stock is mispriced due to a disconnect between the company’s traditional continental European shareholders and the early success of SMILE in unfamiliar Asian markets. Our channel checks indicate SMILE is gaining traction in the U.S. and Europe as well, where launched, with volumes set to accelerate following post-COVID reopening.

As a result of the operating leverage in the company’s model, our FY 9/25 EPS estimate is roughly 2x consensus; in our view the stock offers a low-risk double, or, in a bull scenario (based on a discount to peer PEG ratios), a near quadruple in 2.5 years.

Description and History

CZM is the only listed subsidiary of the 175-year-old Zeiss Group, a global leader in optics technology. The Zeiss Group last year generated revenues of over €7.5 billion and R&D expenditure of nearly €1 billion, across segments including Semiconductor Manufacturing Technology (“Zeiss SMT”), Industrial Research (microscope systems and software), Consumer (eyeglass and camera lenses), and Medical Technology (CZM). The parent company of the Zeiss Group, the Carl Zeiss Foundation, also owns Schott, which invented the heat-resistant borosilicate glass widely used in flasks, reagent bottles, and cookware today.

The greatest testament to the Zeiss Group’s technological capability is Zeiss SMT’s development of extreme ultraviolet (EUV) lithography, the key to ASML’s success as the largest and most advanced semiconductor capital equipment manufacturer in the world. Zeiss SMT’s technology is so advanced there is no alternative on the horizon, leading to ASML’s acquisition of a 24.9% stake in Zeiss SMT a few years ago. Elsewhere in the Zeiss Group, the company has won multiple Oscars for its film lenses, which have been used in blockbusters from the Lord of the Rings trilogy to James Bond films. In fact photos from the first moon landing in 1969 were taken with Zeiss lenses.

Considering the group’s pedigree in optics, it should come as no surprise that CZM has developed leading-edge applications in medical technology. As recently as FY 9/15, the majority of CZM’s operating income came from its microsurgery segment (see above), in which the company believes it has over 50% global market share and is the clear market leader. The company’s big break in ophthalmic devices came in September 2016, when the FDA approved CZM’s femtosecond laser for its SMILE (small incision lenticule extraction) procedure. CZM’s SMILE technology was conclusively established as the successor to LASIK when, in October 2018, the FDA approved SMILE for patients with astigmatism (just a year before COVID).

Investment Thesis

Breakthrough Technology – In Peter Thiel’s formulation, a breakthrough technology must be an order of magnitude better than the incumbent state-of-the-art in some important dimension. The traditional LASIK procedure was approved by the FDA in the mid-1990s, and in over 25 years, tens of millions of LASIK procedures have been performed, but there has been only incremental improvement in the technology. While the success of LASIK has been impressive, the procedure has barely made a dent in the ~2 billion global myopic patient population. The key reason, apart from cost, is the invasiveness of the LASIK procedure and potential for long-term complications to something as fundamental as eyesight. SMILE fixes this by eliminating the need to create a corneal flap (which causes corneal nerve injury associated with dry eye) and reducing the incision by a factor ~10x. This is accomplished with a faster surgeon consultation time, a faster procedure time, a faster patient recovery time, and at the same price as traditional LASIK.

Unit Economics – We will focus on the two core earnings drivers, namely SMILE and to a lesser extent multifocal IOLs. As mentioned above, SMILE is monetized with a razor-and-blade model; CZM’s latest generation Visumax 800 femtosecond laser retails for €300,000, with a €200 consumable charge per surgery. While the price of the Visumax 800 is slightly higher than legacy LASIK machines, the faster procedure time (the actual cut lasts a few seconds), lower consultation time (typically a large expense for clinics), and smaller footprint (suitable for tight high-street clinics) result in higher RoIs for clinics. Based on our discussions with the company, we believe the Visumax generates gross margins of 50-55%. The consumable portion is a mix of a “treatment pack” (to keep the laser hygienic) and a “per-click” license fee; the per-click fee allows CZM to prevent clinics, especially in emerging markets, to jerry-rig the machine and treatment pack: i.e., if a clinic doesn’t pay the per-click fee, the machine doesn’t work. We believe the consumable portion generates gross margins of 85-90% and will be the largest driver of earnings. Multifocal IOL implants are used in higher income cataract patients, and the brand of the implant is not dependent on the brand of the phacoemulsification machine; CZM does not have a monopoly in this relatively new product segment, but according to our channel checks, it does have the highest market share in China (where SMILE is also popular) and a few other markets, and it is expected to receive approval in the U.S. this year. According to Alcon, the U.S. was the last major market to approve their multifocal IOLs (in 2019), and today Alcon has ~80% market share in the U.S., generating nearly $1 billion in run-rate revenues; Alcon has said multifocal IOLs are the highest gross margin products in their entire portfolio. CZM’s multifocal IOL ASP is in-line with Alcon’s at ~€1,000; considering CZM has higher share than Alcon in more competitive markets like China, we believe CZM will be able to take meaningful share in the U.S. (doctors in the U.S. typically offer 2-3 brands of IOLs). Cataract IOLs are a longer-term opportunity for CZM considering the size of the global cataract market: e.g., India alone accounts for 8 million cataract surgeries annually. 

Asia is a Leading Indicator – LASIK in the U.S. was a rapidly growing market between the mid-1990s until the global financial crisis, after which volumes have never recovered to pre-GFC levels. Prior to SMILE there was no exclusive LASIK technology (Alcon and JNJ are the leading vendors), so patients chose their LASIK surgeon based on word-of-mouth and the surgeon’s influencer clientele (this is changing, see below). In Asia (especially mainland China, South Korea, Taiwan, Hong Kong, and Singapore) there was no meaningful legacy of LASIK, so when SMILE arrived it was perceived as a step-change in myopia treatment: the safest, fastest, highest-tech, luxury cosmetic procedure available. We can see the results in the several Asian eye clinic chains: at Aier Eye Hospital Group (~$30 billion market cap) in mainland China, SMILE revenues are growing at nearly 50% YoY; at Universal Vision Biotechnology (“UVB”; ~$800 million market cap) in Taiwan, SMILE accounted for 5% of refractive surgeries when launched in 1Q20, 20% by 1Q21, and over 50% today – SMILE is not a substitute for LASIK, it is significantly growing the refractive market size. UVB is generating operating margins and RoEs of 30%+ each on the back of its success with SMILE. A recent Hong Kong eye chain IPO prospectus included forecasts for SMILE penetration in the city: Frost & Sullivan (to be discounted) projects 45,000 SMILE cases in Hong Kong by 2025; if we extrapolate this to mainland China on a per capita basis (similar affinity for luxury cosmetic procedures), the long-term volume opportunity in China alone is ~17 million eyes (two eyes per case). We are projecting a small fraction of this for the global SMILE market in 2025, but it provides a sense of the TAM.

Secular Tailwinds – While increasing wealth in greater China, Southeast Asia, and India has been a longstanding driver of luxury consumption (including refractive surgery), the digital lifestyle adopted by children during COVID lockdowns is possibly a greater tailwind. Just prior to COVID, the NIH had estimated that twice as many young adults have myopia in the U.S. compared with the 1970s. Increased home learning around the world on tablets and computers during COVID has driven youth myopia incidence even higher, creating greater future demand for SMILE.

Positive Clinic Feedback – The popularity of SMILE is apparent in Asian eye clinics, but, as we described above, penetration in the U.S. is still low. This is largely due to the late FDA approval in 2018, just prior to COVID. However, we do have evidence that, in the major metropolitan markets where SMILE has been introduced, it is popular. Samples from three U.S. clinics: Clinic A (celebrity surgeon in Beverly Hills) – “[SMILE] is not yet half [of refractive surgeries], but it’s going in that direction;” Clinic B (first SMILE center on the West Coast) – “[SMILE] is almost half [of refractive surgeries];” Clinic C (has served congresspeople and NFL players) – “SMILE is super popular [and accounts for] more than half [of refractive surgeries]” In all of these clinics, SMILE is priced the same as traditional LASIK, and it seems clear that as the economy reopens post-COVID and the replacement cycle works through 2^nd and 3^rd tier cities in the U.S., SMILE will become the dominant refractive surgery.

Near-Term Catalysts – Apart from increasing elective procedures post-COVID (CZM’s Visumax has an installed base of ~1,500 machines, but only ~300 were sold in the past 1.5 years), in the most recent earnings release the company provided a rare look at its order intake growth; while companywide revenues grew only 11% in the quarter, the order book (~75% ophthalmic machinery) grew 24%. Sell-side analysts have barely updated their estimates despite the positive installed base leading indicator provided by the company, partly because the stock has moved lower recently, and partly because, according to the company, many analysts are still thinking about the pre-COVID/pre-SMILE single-digit growth environment for the company. This sets the stage for a multi-quarter earnings upgrade cycle, after which the long-term potential, as we have described above, should become more clear to analysts. The company is still covered primarily by domestic German and regional brokers; just prior to COVID, the company had planned its first Asian NDR, which was cancelled. We expect more Asia-focused investors (in the U.S. and in Asia) to focus on CZM, as APAC will account for more than half of revenues in the near future.

Competition

As we mentioned above the refractive surgery market in the U.S. has not recovered post-GFC, and as a result Alcon and JNJ have under-invested in this segment for years. Alcon barely discusses refractive on earnings calls, and Alcon IR admits that CZM has a strong position in the Asian market. In terms of next-generation refractive surgery, CZM has a multi-year IP advantage; the only competitors on the horizon are two smaller European companies: Schwind from Germany and Ziemer from Switzerland. Even if either of these companies is able to come technologically close to SMILE in the next five years, the sales and distribution heft of CZM (which leverages Zeiss Group distribution) will be difficult to match.

We are not baking in much upside from U.S. multifocal IOLs (to launch this year), but as we mentioned, in many markets where CZM’s IOLs have been approved, they are the preferred choice of surgeons (ahead of Alcon, which is highly dependent on its U.S. IOL business).

Valuation

We believe CZM’s monopolistic profile most closely matches Angelalign (Chinese dental aligner), Dexcom, and Intuitive Surgical. In our base case we are valuing the business on a PEG of 1.25 in FY 9/24 (off of FY 9/25 EPS and FY 9/26 growth), in our bull case a PEG of 2.00 (the bull case PEG is a discount to all three direct comps above). This results in a base case target of €263/share and a bull case target of €514/share in 2.5 years. Alternatively if we apply a direct peer group (above) average P/E multiple to SMILE and a broader peer group (bottom) average P/E multiple to the remaining business, the base and bull case sum-of-the-parts valuations would be higher than our target prices. The key FY 9/26 assumptions on SMILE are ~3.2 million eyes and a Visumax utilization of 12 surgeries/week; on multifocal IOLs, we assume 20% market share in the U.S. in FY 9/26 (see the summary P&L and comps below).

Risks

China – A trade war impacting CZM cannot be ruled out; however, CZM has a manufacturing facility in Guangzhou, and the company has said if China requires Visumax to be manufactured domestically in China, it is prepared to use its Guangzhou facility. We do not believe China’s volume-based-procurement measures will impact SMILE, as it is a niche, luxury product.

Margins – While the company’s official near-term operating margin guidance is “sustainably above 20%,” we believe the company’s operating margins will reach 30%+ in a few years due to the consumables mix. The company did not disagree with our assumptions, but it is possible the company will significantly ramp up R&D and sales activity to increase its moat and target new markets (India, Latin America). In fact most of the company’s current R&D is spent on ecosystem digitization, making the workflow easier for surgeons but not generating near-term direct revenue. The company has not ruled out meaningful acquisitions either. In any case we believe the company’s capital allocation track record is strong, and any incremental expenditure should be value accretive.

Catalyst

Near-Term Catalysts – Apart from increasing elective procedures post-COVID (CZM’s Visumax has an installed base of ~1,500 machines, but only ~300 were sold in the past 1.5 years), in the most recent earnings release the company provided a rare look at its order intake growth; while companywide revenues grew only 11% in the quarter, the order book (~75% ophthalmic machinery) grew 24%. Sell-side analysts have barely updated their estimates despite the positive installed base leading indicator provided by the company, partly because the stock has moved lower recently, and partly because, according to the company, many analysts are still thinking about the pre-COVID/pre-SMILE single-digit growth environment for the company. This sets the stage for a multi-quarter earnings upgrade cycle, after which the long-term potential, as we have described above, should become more clear to analysts. The company is still covered primarily by domestic German and regional brokers; just prior to COVID, the company had planned its first Asian NDR, which was cancelled. We expect more Asia-focused investors (in the U.S. and in Asia) to focus on CZM, as APAC will account for more than half of revenues in the near future.