Tuesday, January 22, 2013

Cooper Companies Offers Defensive Growth

The JP Morgan Healthcare conference is the most important event in the industries calendar and helps set the tone for the rest of the investing year. Typically the pharma/biotech companies outline the key pipeline events of the year or how they plan to expand existing product sales while the medical technology and services companies discuss their prospects for the coming year. I thought I’d help investors compress their research of the event and the sector by providing a brief overview of some of the presentations. In this article I want to flesh out some discussion on the growth drivers at Cooper Companies (NYSE: COO).

Cooper Companies

I last discussed this company in an article linked here and would suggest using that as a primer for this article. There is a guidance update in that the mid-point of this year’s EPS guidance has now been moved to $6, which puts COO on a forward PE of 16.3x, so it’s hardly cheap. On the other hand, investors should be willing to pay an evaluation premium for the quality of its earnings and its recession resistant qualities.

COO generates 80% of its revenues from Coppervision where it competes with Bausch & Lomb, Johnson & Johnson (NYSE: JNJ) and Novartis’ (NYSE: NVS) Alcon division with the provision of soft contact lenses. Although it is a recession resistant market Cooper argue that growth with fluctuate from 3-5% in a recession to 5-7% when trend-like GDP returns. In addition, it is well placed in specialty lenses where it sees itself as being ‘close to number one.’ Since these lenses (multifocal and toric) are faster growing than the general market then COO has been able to grow in excess of the industry.

In a similar vein, a stock like Allergan (NYSE: AGN) is able to generate super industry growth in its ophthalmic products. As contact lenses increase in popularity this should create more trips to opticians who can then diagnose any unobserved conditions that clients may already have. This is good news for Allergan and Cooper who are strong on specialized treatments.

Growth Prospects?

Aside from the growth prospects inherent in its product portfolio, I think there are a few other key catalysts which could provide upside.
  • Lifestyle changes may be responsible for increased incidences of myopia
  • Geographical expansion creates growth opportunities in places like China and Eastern Europe
  • Trading up to more comfortable silicone hydrogel lenses (where COO is investing)
  • Convincing consumers to shift to more profitable once-a-day usage
Now before I get an avalanche of complaints here, let me point out that I do not have a definitive scientific view on the causes of the incredible increased incidences of myopia in certain places of the world, such as Singapore or Hong Kong. Nor do you. However if we look at the research from one of the most widely cited papers in the subject, it claims that, because it is a relatively recent event, the environmental causes are likely to be related to lifestyle changes in the Chinese community. Whatever the causes, myopia does appear to be on the increase and it is occurring in markets like China where Cooper does have growth prospects.

Trading up to once-a-day usage from two weeks or monthly also offers substantive growth opportunities. Cooper claims to generate 4-6x more revenue and 3-5x more in earnings when a customer decides to make the shift to the more frequent lens usage. According to Cooper’s figures only 38% of users are on once-a-day lenses (and a lower percentage in the US) so there is still ample scope for revenue and margin increases from trading up. Furthermore, it is not just Cooper that benefits from trading up. If Johnson & Johnson and Novartis also aggressively push the once-a-day regimen then market awareness will increase for everyone.

Cooper Companies Evaluation

All of this is fine but how does the evaluation stack up?

Firstly, its management made a compelling case for its operating margins to expand from 20% to 25% over the next five years. COO currently pays an 8% royalty on its silicone hydrogel lenses (about 250bp of margin) and there is 100bp of amortization from an acquisition to drop out in future years. This might make investors more comfortable with the evaluation.

Moreover, Cooper is aiming to generate around $1.3 billion in free cash flow. This amounts to roughly 5% of its enterprise value annually. I’d argue that this makes it fairly valued, but I guess an investment decision in Cooper depends on how much of a premium you want to pay for the quality of its earnings. I prefer to monitor closely and wait for a dip.

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