ALC - Alcon: Looking To Break Downtrend Before Entry

Summary

• Alcon has continued in a downtrend since September 2021 with persistent mean reversion activity across this time.
• With FY22 guidance narrowed and macro-headwinds prevailing, forward-looking multiples are less attractive to peers.
• We see a value gap to the downside in ALC and price the stock at $55.
• Based on these factors, we rate ALC a hold.

Investment summary

Pricing factors are currently unappealing for the Alcon Inc. ( ALC ) share price. As seen in Exhibit 1, shares have traded in an extended downtrend since September 2021 having tested the lower and upper bounds of range several times from Sep–date. With ALC recently breaking through the lower bound of support, it needs a large reversal in order to claw back losses incurred this YTD. Valuations are supportive of a neutral view even after adjusting for GAAP earnings.

Based on the culmination of these factors, we rate ALC a hold on a $55 price target.

Exhibit 1. ALC 6-month price action and downtrend

Net volume has ticked down and has pushed lower with downward tilt to long-term price action. Declining volume whilst testing the lower trend line shown above is confirmation of resistance in our estimation.

Price action needs to exhibit reversal

As seen in Exhibit 2, shares have traded in a fairly consistent regression channel, exhibiting numerous instances of mean reversion activity from September FY21 to date. Moreover, looking above at Exhibit 1, shares have broken through the lower trend line whilst net volume has ticked to the downside. The last two times it has done this, there was immediate reversion back to range, however, shares have failed to break through the ceiling of resistance seen on both charts.

Prices are now positioned at the mean-level of price distribution seen across the length of the downtrend. Point is, volatility has been skewed to the downside in this name since the first down-leg began back in September, as seen in Exhibit 3. However, the drawdown in each move to the downside has extended deeper into the red than each retracement back to the upside.

Exhibit 2. Heavy mean reversion activity is seen following each move to the upside and downside.

Taking price action as a proxy for investor psychology on the stock, there's a war between buyers/sellers, however sellers have the market at this point

Exhibit 3. Asymmetrical distribution of volatility-skew with movement to the downside more heavily represented in price action

Q2 earnings marginally supportive

Second quarter earnings came in mixed with upsides at the bottom line versus consensus, whereas revenue came in line, despite growth across all segments. Sales of $2.2Billion were up 10% YoY as international markets recovered from Covid-19. Management note ~100bps of upside at the top from Simbrinza and Hydrus sales [the most recently acquired products].

The surgical business outperformed with 13% YoY growth to $1.3 Billion. Whereas implantable turnover was up 21% YoY to $444 million ("mm"), driven by volumes of Vivity and Hydrus as new additions to the portfolio. Meanwhile, its consumables business grew another 9% to $644mm, driven by recovery in cataract sales from the previous 2 years.

With equipment sales there was another 10% growth on the year to $208mm, however the Vision Care business was single-digit with a 700bps YoY gain to $904mm. For the first half, Vision Care sales were $1.8 Billion, implying a roughly 50/50 revenue split from half to half. Meantime, contact lens sales grew another 11% whilst ocular health turnover reached $357mm.

Moving down the P&L, operating income was down $29mm YoY to $200mm, driven by a ~230bps and ~170bps YoY headwind at the SG&A line and on R&D spend, respectively. This carried down to lower net income and weaker earnings of $0.30/share from $0.31/share this time last year. CAPEX was $237mm for the year as investment increased on manufacturing production lines for contact lenses.

It brought this down to FCF [before dividends] of $233mm [$0.47/share], down from $320mm [$0.65/share] the year prior. Free cash margin was 10% of turnover versus 15% last year. FCF was lower due to increased NWC of $56mm YoY and narrowed CFFO due a lower bonus payment from FY21. Moreover, ALC issued $537mm in EUR denominated senior notes at a coupon of 2.375%, due in 2028. It used funds to pay its $376mm Facility C term loan and another $160mm Facility loan. As a result of the issuance, interest expense is now guided at $210-$220mm, in an increase of $10mm [$0.02/share] on previous estimates.

Reconciliation of earnings to extract true value

Examination of ALC's financials reveals several adjustments to GAAP earnings must be made. First, we capitalize $179mm in R&D expenditure onto the balance sheet [assuming 5-year useful life and straight-line expenditure for amortization], followed by a $59mm adjustment for non-cash impairment in cost of revenue. This provides ALC with $624mm with 'main' SG&A, that is required for ongoing operations. After all adjustments cash operating income lifts to $890mm whereas net earnings lift to $836mm or $1.70 per share.

There are profound changes to book value post-adjustment as well, with shareholder equity adjusting to $10.8 Billion from $19 Billion when adjusting for more than $8.9 Billion in goodwill [non-cash, non-amortizable asset]. The results from these reconciliations are an increase to investment and continuing value [earnings], and therefore, potential increase in corporate value. With TTM return on invested capital ("ROIC") levelling at ~2.5% for the past 4 quarters post-adjustments, this rests below the WACC hurdle of 5.03% following the new debt issuance. Therefore, investment value is weak for the company, as we have tightening average FCF with return on investment that fails to beat the cost of capital.

Exhibit 4. Significant changes to earnings and investment value post-adjustment

Valuation

Shares are priced at 1.6x market cap to book value of equity and 1.8x enterprise value ("EV") to book value. On GAAP presented earnings, we'd be paying an implied price of $65–$72 on these multiples, roughly in-line with current market prices. Moreover, the investor return on equity ("ROE") is unattractive both from earnings and FCF, with an equity duration of >26 years.

Following the reconciliations above, we'd be paying a substantial discount to the current share price, at $36–$39, representing a c.40% discount at the upper bound. FCF ROE is also 500bps at these levels with a payback period of ~14.5 years. Question then turns to if this discount is worth it, or if we are buying into further weakness here.

Exhibit 5.

After completing the respective modelling on forward earnings estimates, shares look expensively priced at a 28% cost of equity, albeit without the payoff to tilt the risk-reward calculus to the upside. We are paying $39 to receive a below-market price of $55 – not worth it in our view. We are seeking asymmetrical price dislocations to the upside, and the risk-reward metrics aren't attractive here.

Exhibit 6.

On the culmination of these factors we are firmly neutral on the stance of ALC. Shares must exhibit some reversal in price action [either backed by earnings or technical factors] to justify entry, or to view some sort of reversal. We value shares at $55 – even after adjusting from GAAP earnings – and believe there is good probability of a reversal to this level based on numerous factors. Rate hold.

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