2023-11-08 01:20:02 ET
Summary
- Bausch + Lomb has made two acquisitions in a short period of time. The acquisitions are huge and are financed by debt.
- I think Bausch + Lomb is taking unnecessary risks.
- However, Bausch + Lomb remains a great company with a safe and consistent earnings model.
Introduction
In August last year I covered Bausch + Lomb. After I set a 'Strong Buy' rating, the stock price rose from $16 to $21 per share. Now the stock is in a downward trend.
Speculators took a large short position, causing the share price to fall significantly. I think they disagree with the big acquisition of Xiidra from Novartis. Bausch + Lomb will also acquire a small business unit of Johnson & Johnson. I think it is good that Bausch + Lomb is growing through acquisitions. But I think the acquisition price of Xiidra is way too high and financed with debt.
I am still optimistic about Bausch + Lomb's products. They offer lenses and formulas for both the mass consumer and those who want the best fit.
I think the purchase price is on the high side, mainly because of the high interest expenses. There are several challenges that make me think that now is not a good time to buy the stock.
Strong Revenue Growth In 3Q23
Bausch + Lomb posted strong sales growth of 6.2% in the third quarter vs. 3Q 2022. Growth factors are evident in the dry eye portfolio because approximately 96% of the U.S. population suffering from dry eye is not currently treated with a prescription product. MIEBO and XIIDRA will contribute significantly to the growth of this portfolio.
LUMIFY, eye vitamins, daily SiHy lenses and Artelac contributed well to overall sales growth in the Vision Care segment. And with the acquisition of Xiidra from Novartis, the pharmaceutical portfolio will be a major revenue contributor in the coming year.
The outlook for fiscal year 2023 has been raised again. Annual revenue is projected at $4.1B and adjusted EBITDA is expected at $735M mid-point. This represents strong sales growth of about 10% at constant currency. Xiidra will contribute about $80M to $90M in revenue and about $30M in adjusted EBITDA.
Bausch + Lomb Has A Competitive Advantage
What I like about Bausch + Lomb is their lenses portfolio. Bausch + Lomb's lenses target the mass-market consumer, as well as consumers who prefer enhanced lenses that are typically more expensive to purchase. This mix gives Bausch + Lomb a stable revenue stream. I wear their Cooper Vision Biofinity monthly lenses and Bausch + Lomb Biotrue One day lenses. And I also use their Renu multi-purpose solution. I find the Bausch + Lomb lenses more comfortable, but they come with a higher price tag. Still, a small disclaimer: I am not an optometrist, but I would like to share my experience.
A good lens is judged by several factors: water content, oxygen permeability, thickness, and more. Consumers each have their own preferences about which lens offers good comfort. But qualitatively, two properties are important for good comfort. These are water content and oxygen permeability. These properties can be compared to different lenses on the market. A water content of about 78% mimics the tear film of the eyes, so consumers do not feel the lenses. Other consumers suffer from dry eyes and need a different water content. It's everyone's personal preference.
An important characteristic to distinguish quality lenses is oxygen permeability. High oxygen permeability keeps the eyes from getting tired easily.
For example, the Soflense series is popular and generates a fair share of sales. These lenses are among the cheapest on the market. The SofLense monthly lenses compete with the Biomedics 55 Evolution from Cooper Visions and the Acuvue 2 from Johnson & Johnson. The SofLense series has the competitive advantage of being the least expensive lenses compared to competitors.
Comfort lenses such as the Bausch + Lomb ULTRA One Day day lenses contain virtually the same amount of water as the human eye. The advantage of these lenses is that they are very comfortable, and you can barely feel the lenses. Lens manufacturers find it difficult to keep the water content high and still maintain high oxygen permeability. Bausch + Lomb has succeeded in increasing oxygen permeability so that consumers suffer less from eyestrain.
The lens market is currently dominated by Johnson & Johnson, Alcon, and Cooper Vision. However, Bausch + Lomb has several competitive advantages. They serve the mass market with cost-effective lenses, and they also serve the market in need of high-quality comfortable lenses.
Growing Through Acquisitions
Brent Saunders, Bausch + Lomb’s new CEO, took office in March this year. He aims to grow the company and recently announced plans to acquire business units from Novartis and Johnson & Johnson.
Xiidra is Novartis' business unit that treats dry eyes and will be acquired for $1.75B upfront. The deal will be completed at the end of this year and also includes investigational products and AcuStream technology. Xiidra generated $487 million in revenue in 2022, so the acquisition price is about 3.6 times annual revenue. Novartis bought Xiidra in 2019 for $3.4 billion, so one might suggest that Bausch + Lomb bought it at a discount.
I think the acquisition price is a bit on the high side. The first quarter of this year reflects well the sales figures of Xiidra before the acquisition. I am concerned about Xiidra's sales growth. First quarter results show Xiidra's revenue fell 17% year over year. Xiidra, however, is currently sold only in the US. Novartis attempted to sell it in Europe, but withdrew the application after the European Medicines Agency expressed major concerns . So there is still growth potential, provided Xiidra can be sold in Europe.
Bausch + Lomb remains optimistic because the prescription U.S. DED field is expected to grow at a double-digit annual growth rate over the next 5 years. DED (dry eye disease) affects approx. 38 million people in the US alone, and approximately 739 million worldwide. Xiidra is patented until 2033, so there is no risk of generics yet.
The acquisition fever is not over yet, as Bausch + Lomb is also acquiring J&J's Blink Eye business unit for $106.5 million in cash. This included various eye drops and contact lens rewetting drops for OTC use.
Acquisition Through Debt
Bausch + Lomb announced that it has placed $1.4 billion (8.375%) in senior notes through 2028 to fund both acquisitions. This will increase interest expenses by $117 million annually. In addition, Bausch + Lomb will enter into $500 million in new Term B loans under the Term Loan Facility. The interest rate on the term loan is currently 8.59% per year. This will increase interest expense by another $43 million. In total, interest expenses will increase by $160 million.
Interest expense makes up a large portion of free cash flow, as shown in the table below. The acquisitions also generate additional profits. But because current cash flows cannot cover the additional interest expenses, I think there is too much risk.
FCF and FCF-margin (Annual Reports)
Xiidra adds value to Bausch + Lomb when the operating margin of the acquired business units exceeds 8.375%. However, I am not aware of Xiidra's operating margins.
Bausch + Lomb's debt load is nearly the same as that of competitor The Cooper Companies. But The Cooper Companies' interest costs are much lower than Bausch + Lomb's. The same goes for Alcon, whose debt load is about twice that of Bausch + Lomb.
Moreover, I wonder if the acquisition price is too high. The acquisition price is 3.6x annual sales, while Bausch + Lomb's PS ratio is only 1.5. So would Xiidra be 2x as profitable as Bausch + Lomb consolidated? This suggests that the acquisition price may still be on the high side.
Moreover, Xiidra is currently sold only in the US and does not seem to be able to expand in Europe. The growth factor is gone. While I was bullish in August 2022, I have now become more cautious.
Short Interest is 11%
Investors (or speculators) are not optimistic because the number of stocks that are short is high (short interest of float = 11%). They believe the stock price will continue to fall because they have not reduced their short position.
Still, I am not pessimistic. Bausch + Lomb sells consumables. Consumption time is short (daily or monthly) and this ensures stable revenues. This reduces the risks of a sharp decline in revenues and therefore resists a recession.
It is possible that the stock price will rise when the short sellers close their positions by buying shares. Because of this, it can be seen as a small catalyst.
Most Attractive Stock Valuation
Bausch + Lomb appears to have the most attractive stock valuation compared to Alcon and The Cooper Companies. The forward P/E ratio is 25.9 and in general I think this is an expensive valuation. Often the inverse of the P/E ratio is taken (the earnings yield) and compared to the current government bond yield. The current yield on 10-year government bonds is 4.7%, and its earnings yield is 3.9%.
P/E Ratio's (Seeking Alpha)
Government bond yields should have a higher premium compared to equities. Benjamin Graham goes a step further and recommends investing in stocks with a premium of at least 200% over triple A bonds . With the current yield on triple A bonds at 5.4%, this would mean that the P/E ratio should be 6.3 or lower. However, there are limitations to this assumption; earnings growth is excluded, among other things.
What we deduce from this is that Bausch + Lomb is attractively valued relative to its sector. But overall, the stock is expensively valued. The time of year tells us that it is more favorable to invest in Treasury bonds than in stocks.
Conclusion
The new CEO of Bausch + Lomb wants to grow the company through acquisitions. The company has made two acquisitions in a short period of time. The acquisitions are huge in size and are financed by debt. The interest charges are so high that they cannot be covered without the revenues from Xiidra. I think Bausch + Lomb is taking unnecessary risks.
More than 11% of shares outstanding are currently short. The share price has already fallen and now offers a cheap valuation compared to industry peers. Still, I think the equity valuation is on the high side. Investors are now better off with safe government bonds. However, Bausch + Lomb remains a great company with a safe and consistent earnings model. Such companies should get a higher allocation in my portfolio if the stock price is right. But for now, I see a number of challenges that put the stock on hold.
For further details see:
Bausch + Lomb: Not A Good Time To Buy (Rating Downgrade)