An
Opportunity in Plain Sight
Before I get in to why we own eye care company Alcon (NYSE:
ACL), I'd like
to make an admission: most healthcare businesses are outside my circle
of competence.
The business of healthcare baffles me. The industry's
well-known inefficiencies offend my sensibilities as a
businessman. That caregivers - doctors and nurses - ever came to be
viewed as "part of the problem" probably speaks more to the industry's
dysfunction to me than any other factor. And the irony that one of the
most successful pharmaceutical drugs in recent history, Viagra, was
discovered by Pfizer by accident - researchers were trying
to treat hypertension - makes
me question the long-term predictability of all
pharmaceutical companies' earnings.
The health insurers' business model clearly faces significant
regulatory risk - if
not now, then certainly at some other point over the next decade. Most
biotechnology companies appear to be little more than off-balance sheet
R&D departments for the big pharmaceutical
companies. While generic drug makers, diagnostic testing
businesses and medical device companies can have appealing economics,
their revenues, too,
face a cloudy future these days.
In short, many healthcare companies have moats created
by federal regulation, and a tremendous number of those
regulatory-based moats appear
under threat. While I have no doubt that there are good
healthcare businesses whose shares are currently oversold, I lack
the expertise needed to confidently invest our money in those
companies. So we probably won't own too many
healthcare companies in our portfolio.
All of which, however, begs an obvious question:
"Why, then, Mr. Smartypants, do we already own shares of a healthcare
company!?!?!"
I thought you'd never ask.
Welcome to Alcon - and the world of special situation investing.
Why
Is This a Great Business?
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 buiness 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.
Now you know why these situations are considered special.
|
Cale's
Notes:
No offense, little red
stub. 