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Stock Strategist Industry Reports

Complexities of Eye Care Drive Strong Moats

We see attractive growth opportunities for the ophthalmology market.

We see strong competitive advantages in the $50 billion ophthalmology market as a result of manufacturing complexity, strict government regulation, limited competition, and cash-paying customers. The eye-care market is made up of three segments: pharmaceuticals, consumer products, and surgical products. All three enjoy favorable growth prospects because of aging populations and new treatment options for previously untreated or undertreated diseases.

Eye-Care Pharmaceuticals
Anti-VEGF treatments for wet age-related macular degeneration and diabetic macular degeneration have been wildly successful, with  Regeneron's (REGN) and  Bayer's (BAYRY) Eylea and  Novartis' (NVS) and  Roche's (RHHBY) Lucentis both easily reaching blockbuster status. Other eye-care pharmaceuticals include treatments for glaucoma, dry eye, and acute conditions such as infections and allergies.

We believe patents and manufacturing complexity drive moats in eye-care pharmaceuticals. Eye medication in drop form is challenging to replicate. Because of eye drugs' localized treatment action, the U.S. Food and Drug Administration typically requires generic competitors to run clinical trials rather than simple blood tests to prove bioequivalence. Additionally, the ophthalmology market is shifting into even more complex formulations--such as injectables, biologics, and implantable devices--which should increase barriers to entry for generic competitors. Less-intense generic competition leads to higher margins for both branded and generic eye drugs after patents expire. The primary generic ophthalmology firms are Novartis,  Valeant (VRX), and  Akorn .

Branded ophthalmology drugmakers, especially  Allergan and Novartis, have enjoyed success with life-cycle management strategies, which provide very high returns on research and development investments. Life-cycle management strategies include rolling out new dosage strengths (Allergan's Lumigan 0.03% to 0.01%) and shifting to preservative-free products (Allergan's Alphagan to Alphagan P). The unique sensitivity of the eye and relatively weak efficacy of current treatments create opportunities for significant improvements to existing drugs.

We are relatively enthusiastic about Regeneron, as we expect Eylea's dosing advantage and the addition of the DME indication to enable continued market share gains in the near term. We also see minimal risk of longer-term disruption from competitors' pipeline products. The market for anti-VEGF therapies for wet AMD and DME continues to grow, driven by demographic trends. In dry eye and glaucoma, we expect Allergan to maintain its dominant position owing to manufacturing complexities and opportunities for life-cycle management. Allergan's wide moat should be further supported by the company's transition to even more complex formulations, including its Novadur implantable device dosing mechanism. Narrow-moat Akorn offers the most direct exposure to one of the few generic drug markets that we believe has favorable economics.

Consumer Eye-Care Products
Manufacturers of eyeglasses, contact lenses, and contact lens solution have very strong competitive advantages, in our view. While these products don't carry the ultrahigh margins of pharmaceuticals, they tend to have greater staying power. Vision correction products are paid for largely out of pocket by individual customers, so manufacturers don't face the same degree of pricing pressure from pharmacy benefit managers, managed care, or government payers as other health-care firms. Even when vision insurance is present, patients can usually choose whichever glasses or contact lenses they want; the insurance company contributes a set dollar amount toward the purchase price, without negotiating directly with manufacturers. Lastly, the need for manufacturing scale and expertise has resulted in highly concentrated markets with few global competitors.

Low global rates of vision correction should provide steady volume growth for decades to come. It is estimated that 4 billion people of the 7 billion global population need vision correction, but currently only 1.6 billion (40%) are receiving it. As standards of living improve in emerging markets, rates of vision correction should increase substantially. Only about 125 million people globally use contact lenses. We expect even faster growth in contact lens adoption, helped by the introduction of multifocal lenses that will increase usage among older demographics and growing penetration of more convenient daily disposable lenses, which drive 2-3 times as much revenue as two-week and monthly lenses.

Laser eye surgery is often cited as a threat to eyeglasses and contact lenses, but we believe its impact will be minimal. Laser eye surgery is a small niche market, given the limited window of opportunity for the procedure (patients' prescriptions typically don't stabilize until they are in their mid- to late 20s, and eyesight normally begins to deteriorate again in patients' late 40s or early 50s) and its high cost (the national average price for Lasik is about $4,000). Even patients pursuing surgery will be glasses or contact lens users before the procedure and again years later when their eyesight deteriorates.

 Essilor (EI) is the largest manufacturer of eyeglass lenses, with an estimated 36% global market share versus its next-largest competitor at 10%. We believe Essilor has significant scale advantages over competitors, and its large research and development budget allows it to further extend its lead through new technology innovations.  Luxottica is the world's largest designer and manufacturer of prescription eyewear frames. It is also the largest eyewear retailer in North America, with brands such as LensCrafters, Pearle Vision, Sears Optical, Target Optical, and Sunglass Hut. The firm uses its retail presence to drive sales of its frames and efficiencies in its finishing labs, while enjoying cost advantages from scale, efficient sourcing, and inventory management.

The contact lens market is dominated by just four companies-- Johnson & Johnson (JNJ), Novartis,  Cooper (COO), and Valeant--which control an estimated 95% of the global market. Cooper offers the most direct exposure to this industry, since the other three lens manufacturers are part of much larger health-care conglomerates. Contact lens sales account for more than 80% of Cooper's total sales.

Economic moats in the contact lens industry result from both cost advantages and intangible assets in the form of manufacturing expertise and technological innovations. Contact lenses must be produced in massive quantities to drive product costs down to meet normal price points. Furthermore, contact lens users are sticky customers. Patients are cautious about what they put in their eyes, and once they are comfortable with a particular lens, they are unlikely to switch for a minor improvement or small cost savings. Although optometrists and ophthalmologists have the power to steer patients to particular products, they too hesitate to embrace a new competitor that doesn't have a proven record of safety. Sauflon, a niche player in Europe, was one of the few companies to pose a credible threat to the big-four contact lens manufacturers because of its early bet on specialty silicone daily disposable lenses. However, Cooper neutralized this threat by recently agreeing to acquire Sauflon.

Surgical Supplies
The eye-care surgical market is largely composed of products related to cataract surgery, which are expected to see high-single-digit growth rates because of aging populations and greater penetration of cataract surgery. Despite the attractive growth rate, the small size of the surgical market means this segment is unlikely to have a material impact on the financials of the health-care conglomerates that control the market. For example, Novartis has an estimated 60% market share, yet surgical sales make up only about 6% of total company sales. At  Abbott (ABT) and Valeant, the next-largest players, ophthalmology surgical products account for 5%-7% of total company sales. Nonetheless, we view this as an attractive niche as a result of strong growth and limited competition, with these three firms controlling nearly 90% of the market. 

David Krempa does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.