Investors got excited over the prospect of Novartis (NVS) becoming a super-scale biotech company following the spin-off of their eye care device segment Alcon (ALC). However, the recent run-up in NVS's share price implies a strong pipeline execution and may be subject to investors’ disappointment given the heightened generic drug competition. Conversely, investors may want to look at ALC as we think it offers a better risk-reward scenario based on its potential for improvement in fundamentals going forward.
Alcon Spin-off – The Background
On 9th April 2019, Novartis disclosed that it has finalized the spin-off of the eye care devices Alcon. The spin-off was carried out through a dividend-in-kind distribution to Novartis shareholders and American Depository Receipts holders, where each holder would receive one (1) Alcon share for every five (5) NVS shares as of April 8.
ALC is the global leader in the $23 billion eye market, dominated by 4-5 players. The company generates c. $7 billion in revenues through its primary segments: Surgical and Vision Care. Alcon’s Surgical segments markets equipment, disposables, and implants used in various ophthalmological surgical procedures, while its Vision Care segment generates sales from contact lenses and OTC eye care products.
The Alcon Spin-off Make Sense
NVS now consists of innovative Pharma business and generics division Sandoz and will be more closely aligned with “focused pharma companies” in the market. According to NVS CEO Vas Narasimhan, this spin-off would allow NVS to fully focus its capital allocation and management attention on drugs. Additionally, it disclosed that a catalyst-rich pipeline of 10 potential blockbuster launches were on the horizon, where 4 drug pipelines are expected to be completed in 2019.
NVS Priced For Strong Pipeline Execution
Since the company’s announcement on their planned ALC spin-off, there was a noticeable run-up in share prices of ~14.2% over the last months. Investor optimism is predicated on the narrative of its ongoing transition to becoming a “super scale” biotech company focused on innovation.
However, we note that the spin-off would provide greater scrutiny on the challenges of its remaining pharma business – marked by intense competition and margin erosion. By our estimates, 52% of the pharma gross profits face generic competition, and NVS is reliant on the high probability of success from its innovation pipeline in order to keep its operating profits afloat from 2021-2028. Consequently, this dependence on imported innovation via M&A, creates execution risk which we find concerning.
There are also notable challenges in the launch execution of their gene therapy Zolgensma (expected approval 2Q 2019), given the novelty of the technology and upcoming competition from Roche’s (OTCQX:RHHBY) risdiplam. While consensus estimates show that Zolgensma will capture 40% of the global spinal muscular atrophy market vs. 20% for risdiplam, we believe the outcome will be a more balanced market share. On the other hand, Novartis is also launching new multiple sclerosis drugs amid the backdrop of rising competition and pricing pressures.
Financial Outlook And Valuation
We think NVS (excluding ALC) will show relatively flattish revenue growth over the next decade but NOPAT can benefit on normalized EBIT margins, which will only materialize on successful pipeline deliveries and investment on cell & gene therapy capabilities.
We think the current share market price implies an optimistic execution of the company’s pipeline in the coming years - we are more cautious and believe there may be risk to the downside.
But, BUY ALCON Instead…
Well Positioned To Capture Growth In Contact Lens Market. Our long-term estimates of global contact lens market growth of ~4% is in line with ALC management expectations. However, we think there is a risk to the upside given growth accelerated to ~8% in 2018, driven by consumers trading up to premium product categories.
Turnaround underway. Following a period of top-line and margin erosion in 2015-2016, NVS management has put a structuring plan in place, including significant investments with the purpose of returning the business to a strong profitability track. We think ALC can grow its revenues, along with EBIT to 2023.
Alco’s Value Will Be Unlocked. Typically, device segments within a giant pharmaceutical business struggle since these pharma businesses focus most of its financial resources around a single drug, which would provide astronomical returns for them. Consequently, this led to the underperformance of several non-drug related businesses.
Post ALC spin-off, we expect ALC’s sales and CapEx reinvestment to drive an inflection in top line revenue growth and margins expansion through 1) reversal of share losses in intraocular lenses (IOLs) and contact lenses derived from gross margins enhancement from offering premium IOLs, production efficiencies and pricing discipline, 2) deploying a flexible balance sheet (i.e. modest net debt to EBITDA of only 1.70X), and 3) capital reinvestment to drive margins as well, which has stagnated in recent years.
Historical Data Favors Healthcare Spin-Offs. Based on our research, the data from 2012-2018 reveal that share prices of major healthcare spin-offs have performed well with a median price hike of +37% 12 months after the transaction. The share price outperformance stems from sharpened focus as a standalone company, customer-driven innovation and better employee morale from company culture turnaround.
Valuation. We think ALCON can achieve a forward multiple in the low-20s on higher earnings, which should drive a higher valuation. While the multiple here is higher than large medical technology peers such as Boston Scientific (BSX) and Stryker's (SYK) ~20X P/E, we believe this is warranted mainly from the potential for upside surprise on EPS in the coming years.
Following the recent increase in NVS's share price from the market’s excitement over the company’s shift to an innovative biotechnology company post-ALC spin-off, the current NVS share price implies a “best-case scenario” for their ongoing pipeline, and appears overpriced relative to reasonable prospects. In contrast, ALC has a better risk/reward profile with better upside potential mainly from their successful turnaround efforts.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.