A Good Way to Start the New Year

Two press releases came out this morning of interest to Tarpon Folio investors.

The first is that Contango announced a successful new natural gas well with production expected to be 20 million cubic feet equivalent per day…or a 25% increase over the company’s current production. Good on ya, Ken Peak. Here’s the press release.

The second bit of news is that Tarpon Folio holding Alcon is being bought by Novartis.

Or, more accurately, Novartis would like to take control of Alcon by buying Nestlé’s majority stake for $28.1 billion, raising its own stake to 77 percent, and said it would like to acquire the rest, currently owned by minority shareholders like the merry band of Tarpon Folio investors (my words) by offering 2.8 Novartis shares for every outstanding Alcon share.

Here’s more from the NY Times. And here’s what I said about Alcon in my Letter to Tarpon Folio investors last July:

By all measures Alcon is a wonderful business. It’s the world’s largest eye care company, with sales in 2008 of $6.3 billion and profits of $2 billion. It has the broadest portfolio of eye care products in three key categories: surgical, pharmaceutical and consumer eye care. If you’ve ever had contact lenses and reached for the Opti-Free, you’re already familiar with one of Alcon’s products. Based in Switzerland but originally founded in Texas back in 1945, the company now does business in 180 countries.

Alcon has a leadership position in the cataract market, helping to prevent blindness and restore sight among those patients that make up the 25 million people affected by cataracts each year. The firm’s Infiniti system, used to remove the eye lens during surgery, represents a big upfront investment and requires loads of training, making hospitals and surgeons reluctant to switch. Similar advantages exist in Alcon’s intraocular lens business, and its large opthalmic drug portfolio targets only a handful of diseases, so the same salespeople can sell each drug. That saves the company a bundle.

Since going public in 2002, Alcon has averaged returns on invested capital of greater than 40% a year. So it clearly benefits from the high switching costs of its products as well as the efficiencies of cross-selling. While its revenues are susceptible to cuts in government health-care spending, that should be at least partially mitigated due to a dramatic expected increase in eye-related diseases as baby boomers age and new emerging markets get better access to health care.

Here’s the thing about Alcon, though: none of the above really matters to us the next few years. The business described above really just provides us with a margin of safety in the event I’m wrong about certain future events that will enable us to profit further from owning Alcon shares. But I like our odds very much.


What Makes This Situation Special?

I probably couldn’t tell a ophthalmic viscosurgical device from a toric intraocular lens if either one fell into my conch chowder. So why would I so brashly ignore that earlier “stay in your circle” advice we got from the world’s greatest investor? Because Alcon is an example of what is called “special situation investing” – and, yes, Buffett used to be quite active in these opportunities, too, some time ago.

Special situation investing involves taking a position in a company based primarily on certain advantageous circumstances, as opposed to relying exclusively on fundamental research. You probably didn’t realize it, but the Tarpon Folio contains several special situation investments, including – please excuse the jargon – a spin-off, a broken IPO, and a disguised recapitalization. Alcon came public as a “carve-out”, another kind of special situation, but now it is of interest as a likely merger arbitrage case. I’ll explain each term more in future letters. For now, here is what makes the Alcon opportunity so compelling.

Public shareholders like you and I hold about 23% of Alcon’s shares. Currently, 52% of Alcon is owned by Nestle. In April of last year, the company Novartis bought a 25% stake in Alcon from Nestle in exchange for $11 billion and an option to buy out all the rest of Nestle’s Alcon shares beginning in 2010.

Then, last fall, the credit crisis happened and Alcon’s shares plummeted even further after missing an earnings forecast. This represented a tremendous opportunity for anyone who had been paying attention while, say, pounding caffeine as he studied various companies to include in a new fund to be named after a fish.

Despite being a great business, I was most excited about Alcon last fall – and still am today – because of the terms of Nestle’s deal with Novartis. In short, starting on January 1, 2010 and for a period of 19 months, the rest of Alcon shares are likely to be sold to Novartis in one of two ways:

1 – Novartis may either exercise a call option to buy Nestle’s remaining stake in Alcon for $181 a share; or

2 – Nestle may exercise a put option to sell its Alcon shares to Novartis at the lower of $181 a share or a premium of 20.5% over the market price.

In either case, large amounts of Alcon shares are likely to change hands at prices that will either be $181 a share, or if lower, still 20.5% above whatever price the shares trade at the week before Nestle may decide to “put” its shares to Novartis. Here’s the SEC filing that announces the transaction.

This brings up two questions:

1 – If two savvy billion-dollar institutions with decades of experience in this industry mutually agree that the true value of Alcon shares is really $181 each – might that not be a reasonable assessment of the intrinsic value of those shares?

2 – If you owned 77% of something but couldn’t guarantee you’d completely maximize the benefit you derived from it, wouldn’t you just buy the rest of it, too?

I think the answer to both questions is a big ol’ “yes.” As a result, I believe the odds are high that investors in Alcon shares at prices similar to today’s (around $130 a share) will make at a minimum a 20% return on their investment over the next few years – and likely sooner rather than later.

What Are The Odds Of Success?

I believe we have a 75% probability of seeing at least a 20% return on our Alcon shares within the next two years due to this transaction. Importantly, that return would be regardless of whatever the broader stock market does.

If Alcon shares rise from their current $130 level to $181, we’ll make more than that 20% without a transaction. If the transaction falls through, we still own shares in a great company that appears significantly undervalued. And should changes in U.S. healthcare policy spark consolidation in the industry, it seems likely that Alcon might make an attractive candidate for another eventual suitor.

Both Nestle and Novartis have recently expressed their intent to honor the terms of the existing agreement. Ironically, the higher Alcon’s share price climbs in the interim, the higher the probability the transaction will be completed. That’s because the only potential sticking point in the deal would appear to be the price. With Novartis paying $143 per share for its Alcon stake last April, the closer shares trade to that level, the less grounds Novartis should have to renegotiate in any case.

The acquisition of Alcon also looks to be a strategic necessity for Novartis, which presumably wants to reduce its reliance on its biggest-selling drugs, the hypertension treatment Diovan and the cancer drug Gleevec, since they will be losing patent protection in the next few years.

In addition, Nestle clearly holds the position of strength in this deal, as the returns it is earning on its stake in Alcon are significantly higher than the low interest it would earn on the cash it received from selling Alcon. Nestle appears in no rush to unload its shares, while Novartis is constrained a bit in its own operations by this agreement because it must retain enough cash on hand to buy Nestle’s Alcon stake on little notice after January 1st, when Nestle could exercise its put option and force the sale. That’s why I think the sale will happen earlier in the year – it’s handcuffing Novartis a bit.

I believe that high probability above may become a near certainty, as Novartis will likely be inclined to simply buy out the remaining public shareholders as part of the Nestle transaction. Why? I’ll spare you a discussion of consolidated accounting methods, but think of it like this:

The economic value of Alcon to Novartis is not the profit that shows up in its (sort of) combined results. The real value of Alcon to Novartis is in being able to redeploy those profits internally any way Novartis sees fit. And as long as Novartis has us pesky public shareholders hanging around, we might represent a risk of gumming up the plans for those profits.

So, Novartis will probably eventually offer to buy us out, too. And I think we already have a pretty defensible opinion about what our shares should be worth to them, no?

What Happens Next?

Simply put, we wait and see. As long as Alcon shares trade below $181 per share (they’re near $130 today) we have little incentive to do anything else. In the meantime, we’ll collect dividends of just under 3% from an undervalued company with world class products, strong competitive advantages and superior economics.

You can sign up to receive my monthly letters here, and view my 2009 letters here. Also, to see what stocks are in the Tarpon Folio now, sign-up here.

Note: The implied purchase price for minority shareholders in the Alcon deal above is $153 per share, which is lower than where the stock last closed…but it’s nonetheless considerably higher than Tarpon’s original purchase price of $73. I’m also positive on the announcement today as I think it’s a safe bet that the independent directors on Alcon’s board will push for a higher price. The market seems to believe this, too, with shares trading at $157 at noon today. Plus, Novartis is a cash machine with a growing dividend, huge presence in generics and an attractive pipeline. I’m not an expert in pharma by any means, but I can think of worse things than backing into Novartis shares through this deal.

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Cale Smith

About Cale Smith

Portfolio Manager at Islamorada Investment Management.

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