Description

Bausch + Lomb (BLCO)

Thesis

The story of Bausch Health (NYSE: BHC) is not one for the faint of heart. It involves large amounts of leverage, legal disputes pertaining to all aspects of the business, involvement of almost every notable activist hedge fund, and a highly fluid set of circumstances. Notwithstanding the complexity of the BHC situation, one meaningful green shoot is emerging and the potential to realize close to 50% upside over the next 12 months in one of the most defensible business models out there. It is not the story of BHC but the story of its recently spun-off eye health business Bausch + Lomb (NYSE: BLCO). 

The Bausch + Lomb brand is a staple for those familiar with contact lenses and the world of eye care products. However, up until recently, it was not an investable name in its own right. That changed in May-22 with the initial (and somewhat disappointing) 10% public offering that netted BHC ~$675mm in proceeds. Today, BLCO’s equity has a market value of ~$5.3bn but remains tightly held by its former Parent. BHC retains ~88.7% that is currently valued at ~$4.6bn. The effort to monetize a partial stake in BLCO was kicked off by an existential crisis at BHC. The company, which some might know better still as Valeant Pharmaceuticals, is a highly levered pharmaceuticals business that over the last few years has been facing rapidly mounting challenges related to unsustainable leverage, looming patent expiries, and securities fraud lawsuits. In particular, the patent on the company’s core drug Xifaxan has been challenged in court recently with a federal judge partially invalidating its exclusivity. While BHC is appealing the judgment, it is set to lose up to ~50% of current EBITDA by FY24 should the drug lose its exclusivity. Considering these challenges, BHC’s ~9bn of unsecured debt had been trading at distressed levels since mid-2022. The Parent recently conducted a distressed exchange, uptiering ~6bn of face in Unsecured Notes to ~$3bn of new Secureds. Importantly, this transaction lowered its pro-forma leverage to ~6.7x, the level required for BHC to unrestrict the subsidiary that holds the majority of its remaining BLCO stake. Due to the continued overhang of BHC ownership, lack of liquidity 

The global ophthalmology market is underpinned by attractive features. For the most part, it is an oligopoly between four major competitors (J&J, CooperVision, Alcon, and BLCO) that has been growing above GDP for 15+ years and is expected to continue to do so buoyed by secular trends including (i) ageing populations (ii) shift towards middle class in emerging countries (iii) increasing incidence of eye conditions such as myopia in younger generations. Ophthalmology businesses have significant R&D and capex intensity (spending ~11-15% of sales on average) but also benefit from resilient demand and pricing power given the non-discretionary nature of its products and customer focus on quality.

BLCO is at the cusp of material changes to its capital allocation policies with a clear line of sight into significant shareholder returns and an accelerated path to growth medium term once past underinvestment has been fixed. Over the FY18-21 period, BCLO generated $3bn of OCF and spend ~$730mm on capex (~5.7% of sales vs peers at ~7-9%) implying cumulative FCF of $2.2bn (i.e. 40% of its current market cap). Of this amount, the company transferred virtually all of it its former Parent in the form of dividends to service BHC’s high debt service cost. Even under normalized capex assumptions and assuming growth in-line with the market, BCLO will generate close to ~7% FCF yield in the outer years. 

The company currently trades at 9.7x FY23 EBITDA vs pure-play ophthalmology peers at ~13.4x average and pharma peers at ~11.6x average. Similarly, it trades at ~14.3x FY23 EBITDA less capex vs pure-play ophthalmology peers at ~17.4x average and pharma peers at ~12.6x average. On a weighted basis for BLCO’s earnings (~80/~20 ophtho/ pharma), this implies ~46% upside on BLCO equity on EBITDA and ~26% upside on EBITDA less capex.

Business Overview

BLCO is the #4 ophthalmology player with the most diverse portfolio amongst peers across (i) contact lenses (ii) consumer health (lens care/ eye drops/ vitamins) (iii) surgical (iv) ophtho pharma.

The company has $5.3bn market cap/ $7.4bn TEV and currently operates in three segments:

• Vision Care (~63% LTM revenues/ ~25% EBIT margin)

• Contact lenses

• In contact lenses, four existing key products represent ~80% of revenues (of which two legacy lenses have been in run-off mode with high teens declines in revenues)

• BLCO is planning a new SiHy product launch in 2022 that is an end market with 10%+ growth; BLCO sees peak sales of $250mm for this product alone relative to $881mm total LTM lens revenues

• Optical health products

• These products represent the strongest part of BLCO’s portfolio consisting primarily of lens care, eye drops, and eye vitamins 

• BLCO has ~95% market share in eye vitamins and ~50% market share in redness reliever (the category has been growing at ~25%+ CAGR since its 2018 product launch) 

• BLCO’s strategy here has been focused on product extensions to maintain market share and expand DTC offering (products are primarily cash pay with greatest pricing power across BLCO business) 

• Surgical (~19% LTM revenues/ ~10% EBIT margin)

• Core products are surgery equipment for cataract surgeries (including surgical consumables/ implantables) 

• BLCO is an increasingly marginal player in this market (~7% market share) given underinvestment in its product offering that has led to anemic growth and erosion of margins 

• Innovation pipeline appears piecemeal and will likely only result in catch-up to peers vs true innovation 

• Ophtho Pharma (~18% LTM revenues/ ~41% EBIT margin) 

• Diversified portfolio of over 100 prescription drugs (with none representing more than ~15% of segment revenues)

• Key drugs address AMD, dry eye, glaucoma, diabetic macular edema, conjunctivitis 

• BLCO consolidated margins have been pressured for the most part due to this segment’s margin decline from 48% in FY19 to 41% in FY21

• Ophtho Pharma margins have declined due to a number of lost patent exclusivities since FY19, primarily its LOTEMAX anti-inflammatory drug

• The Ophtho Pharma pipeline primarily consists of three new drugs set to be launched by 2023 with significant revenue upside potential (not currently baked into underwriting given pending FDA approval)

Relative Performance

BLCO is the #4 player in ophthalmology with the most diverse portfolio across (i) contact lenses (ii) consumer health (lens care/ eye drops/ vitamins) (iii) surgical (iv) ophtho pharma. Formers have qualified BLCO as present in every segment but struggling to compete with each relevant incumbent.

BLCO’s ophthalmology peers Alcon (ALC) and Cooper (COO) both operate more focused portfolios with higher respective market shares and stronger historical growth. ALC dominates the $11bn surgical market (~45% market share) targeting cataract and laser surgeries that is set to grow 5% LT due to increasing volumes in an ageing population.

The surgical market drives its revenues from the installed base of surgical equipment, often sold at low margins to lock hospitals/ surgery centers into demand for consumable products typically tied to equipment (e.g. hosing and blades). Most of the margin in surgical is made on so-called “implantables” i.e., intraocular lenses (IOLs) that represent 70%+ of profits (especially premium IOLs that carry 7-10x ASP vs standard IOLs). BLCO appears to be very late to this market with its own premium IOL offering with ALC/ COO/ J&J all entering 5+ years ago). BLCO is only set to launch its premium IOL product (enVista) in 2023 and, in the meantime, has been increasingly forced to compete with its legacy product at the low end of the market. As a result, surgical margins lag ALC by 10+ points and have stalled in recent years. Typical IOL life cycles are relatively short (12-18 months) with successful new product launches historically able capture or re-capture market share quickly. The dynamic could be positive for BLCO, but its product is perceived largely as catch-up to peers vs true innovation. Given underinvestment, BLCO has performed particularly poorly in implantables where ALC has taken meaningful market share given its new IOL pipeline. ALC grew implantables revenues at 12%+ FY19-21 CAGR while BLCO implantables revenues declined by ~2.5%. Former have highlighted that BLCO is currently picking up the scraps from ALC in implantables and is “4-5 cycles behind the competition in terms of innovation.”

BLCO’s surgical equipment offering has also experienced underinvestment with its flagship cataract equipment (Stellaris Elite) launched in 2010. This compares to ALC equipment life cycles of 7-10 years. Installed equipment typically drives consumable demand that is technically tied to equipment while IOLs are more fungible. BLCO’s surgical business is sub-scale (~7% market share) and has displayed FY19-21 revenue CAGR of just ~1.4% vs ALC Surgical at ~6.1% and the market at ~3%. The Surgical segment represents a small part of BLCO with ~20% of revenues/ <10% of profit given low operating margins onf ~10% vs lenses/ ophtho pharma at 25%+ and ALC Surgical at 20-25%. Lack of growth is reflective of BLCO’s historical capex spend of ~2.5% of revenues vs normalized levels of ~5.0%.

COO is exclusively focused on the contact lense market where J&J/ ALC are also major players. Peers represent the #1 to #3 position with a combined ~60% market share and have grown FY19-21 revenues at 4%+ CAGR (in-line with the market). BLCO is #4 with ~15% global market share and a low historical revenue CAGR of ~2.6% in FY19-21.

While BLCO’s global lens market share has declined by ~1.5 points since 2015, its U.S. market share increased ~6 points driven by its recent lens launch (see below). BLCO’s lag in growth vs peers is primarily due to material declines in two legacy products (representing ~40% of FY21 revenues). Soflens (its highly commoditized single-use lens has become increasingly pressured by low-cost Asian market entrants) with product revenues contracting by ~4% annually. Similarly, PureVision (its most legacy lens launched in 2004) has seen revenues contract by ~10% as the product is in run-off mode with no new user adoption. Excluding these challenged legacy products, however, BLCO lens revenues grew at ~11% CAGR in FY19-21 driven by strength in its Bausch + Lomb ULTRA brand. The company also launched a silicone hydrogel (SiHy) lens INFUSE and expects $250mm peak sales vs $890mm FY21 total lens sales)

The SiHy is expected to significantly outgrow broader U.S. lens market. Legacy lenses are expected to grow by ~2.5% through 2030, the SiHy market is set to triple to ~$3.0bn in 2030 (~11% CAGR). SiHy adoption is driven by superior product qualities (e.g. oxygen permeability to the eye) and ASPs are ~50% higher than for conventional lenses). BLCO again is late to market in SiHy (peers launched 2008-13) but expected to benefit from significant segment growth.

BLCO also competes with ALC in the ocular health market. Some of BLCO’s highest quality products are in this segment. Its eye vitamin franchise Ocuvite/ PreserVision is BLCO’s #1 revenue driver and has >95% market share in the US. The franchise is set to lose patent in 2025 but has strongest brand recognition which should dampen sales impact vs drugs. BLCO launched redness reliever LUMIFY in 2018 and has grown it to ~$120mm LTM revenues; the product went from 0% to ~50% market share in 3 years. Formers have called out this product as a potential ~$1bn franchise. Overall segment revenues grew by ~2.8% since FY19 vs ALC Ocular Health by ~6.4% mainly due to declines in BLCO legacy product renu

BLCO’s optho pharma business sets it apart from peers who do not operate in this market. The segment has been a drag to overall growth given material declines in revenues from loss of exclusivity in its LOTEMAX drug (~$115mm negative sales impact since FY19). A further LOE for PROLENSA is upcoming in 2023 and will likely have an additional ~$40-50mm negative sales impact. On the other hand, BLCO has three key near-term drugs in its pipeline that could represent ~$40mm in revenues by FY24 (two still pending FDA approval):

• XIPERE (launched in 1Q22) – eye inflammation drug with 125k U.S. prevalence

• NOV03 (to be launched in 2023) – dry eye drug with $3bn TAM

• bLucentis (to be launched in 2023) – macular degeneration drug with $6.5bn TAM to compete with Genentech incumbent drug

Formers have attributed the lack of growth in the business to underinvestment during BHC ownership (especially in surgical and ophtho pharma segments)

• FY19-21 BLCO average capex was ~5.7% of sales (vs 8.8% for peers)

• FY19-21 BLCO average R&D was ~7.1% of sales (vs 9.6% for ALC; COO less R&D intensive given lens focus)

• BLCO appears to have underinvested to the tune of ~$600mm over the last three years alone while making $1.5bn in cash transfers to BHC

Valuation

Summary Cash Flow

Illustrative Discounted Cash Flow

Catalyst

Full separation from BHC