Alcon's Growth Stymied by the Economy

By Jason Napodano, CFA & Brian Marckx

Alcon, Inc. (ACL) faces some challenges in the near future: patent expiration, patent challenges, generic threats, softer pricing on certain of its products and Medicare rebates. Additional near-term challenges come from slower top-line growth due to a weakening economy and negative foreign currency affects.

The company also took significant losses on its investment portfolio which, by our calculations, negatively impacted EPS by as much as $0.24 in the fourth quarter and $1.22 for all of 2008. The company has subsequently begun redeeming all investments and expects to be 90% invested in cash-equivalents by mid-2009. This should help reduce or eliminate any further investment losses.

However, even in the face of these challenges, the company posted solid operational growth in 2008 and through the first quarter of 2009. Excluding the affect of foreign exchange, sales grew 10% in 2008 and were up 5% in the first quarter of 2009. EPS grew 11% in 2008, and increased 9% in the most recent quarter.

While we expect sales growth in 2009 to moderate relative to that realized in 2008 due to a foreign exchange headwind and softening global economies, Alcon's business model remains fundamentally very strong. The company has done an excellent job with cost-control which should continue to benefit operating margins. The recently announced cost-cutting initiative should be fully implemented by the end of 2009 and shave an additional $40 million in annual expenses. This should help offset some of the impact from generic TobraDex, the slowing economy and foreign exchange headwind in 2009.

Our model reflects the more challenging operating environment that we expect will persist through the end of 2009. Further into 2010 and beyond, however, we believe Alcon's revenue growth will reaccelerate to an annual rate in the mid-to-high-single digits. EPS should grow faster than revenue as operating leverage improves from cost-control measures and gross margin expansion.

Continued international penetration and market share gains will be the fuel for future revenue growth at Alcon. Sales in emerging markets, including China, Russia and India continue to be big contributors to growth. The company generates a significant amount of operating cash flow which we would expect to be reinvested in the form of increased R&D in an effort to restock the company's drug portfolio following certain patent expirations. Cash flow may also be returned to shareholders through another share buyback program which may be initiated now that Novartis (NVS) has completed the initial purchase of Nestlé's stake in the company.

Alcon is already putting some of that cash to work in the form of dividends. The board of directors recently voted in favor of increasing the dividend by 50%, from 2.63 Swiss francs to 3.95 Swiss francs. This equates to a yield of 3.3% at today's share price and exchange rates.

We expect EPS to average about 9% annual growth from 2008 through 2012 on a top-line growth rate of about 5%. For 2009, we expect EPS to grow 2% and for revenue to decline 1% due to consumers cutting back on discretionary purchases, foreign exchange and generic competition to TobraDex. We rate the shares a Hold with a $120 price target, representing 19.5x our 2009 EPS estimate of $6.14.