Monday, December 30, 2013

Cooper Companies Offers Great Long Term Prospects

In a world where investors make knee-jerk reactions to the latest quarterly earnings reports, it's sometimes difficult to focus on the long term. In the case of the soft contact lens industry, Foolish investors are faced with an industry with pretty secure long-term growth prospects. The only significant players are Johnson & Johnson and Novartis'  Ciba unit, with Cooper Companies  coming in third. Meanwhile, Valeant's  2013 acquisition of Bausch & Lomb puts it in fourth place. Cooper is the closest to a pure eye-care play among them, and it presents an interesting proposition for long-term buy-and-hold investors.

Cooper Companies' long-term growth
According to independent analysis, the soft contact lens industry is intended to grow at a rate of nearly 6% from 2012-2016. Indeed, Cooper companies reported that worldwide industry growth was at 5% this year. However, its CooperVision unit (around 80% of revenue, with CooperSurgical making up the rest) reported soft contact lens sales up at a more impressive 10% this year.

Essentially, CooperVision has the opportunity to grow faster than the market for four key reasons.

First, Cooper's silicone hydrogel (more comfortable, longer-lasting) lens sales grew at 19% (constant currency) in the fourth quarter, and are set to grow faster than the market. Moreover, since silicone hydrogel lenses make up 45% of its CooperVision's total revenue, Cooper can grow ahead of the market. In particular, its Biofinity (monthly, silicone hydrogel) lens has a growth opportunity in the US from customers trading up.

Second, industry wide single-use lens sales grew at 10% over the last 12 months, and CooperVision's single-use lens sales increased by 18% (constant currency) over the last year. They made up 21% of CooperVision sales in the fourth quarter. Going forward, Cooper is gearing up for an aggressive expansion of its MyDay (daily, silicone hydrogel) lens in Europe. Customers trading up to its single-day lens generate four to six times more revenue and three to five times more profit. In other words, Cooper has a revenue and margin expansion opportunity with MyDay, but it will take a few years to come to fruition.

Third, Cooper's specialty lenses (toric and multifocal) grew at 8% and 19% respectively in the fourth quarter, and now contribute nearly 40% of CooperVision revenue.

Finally, CooperVision's Asia sales grew at 11% (constant currency), and Cooper's management claims to have good growth opportunities with its Biofinity lens.

All told, it's not hard to see why analysts have the company growing revenue at more than 7% for the next few years.

Johnson & Johnson, Novartis and Valeant report
With a 43% share of the market, Johnson & Johnson is the No. 1 player, but its growth in the third quarter was a far more pedestrian 3.9% (constant currency). Moreover, its U.S. sales only grew 1.9%. Johnson & Johnson has a dominant market position in the two-week modality in the US and this may prove difficult to defend in future, as single-usage lenses gains popularity. 

Novartis operates Ciba Vision (25% of total market) out of its Alcon division, and its contact lens revenue was up 6% (constant currency) in the third quarter with growth driven, unsurprisingly, by its daily lenses and silicone hydrogel lens called AirOptix. Meanwhile, Valeant's Bausch & Lomb (9% market share) launched a one-day lens this year, but the parent company's main focus is on integrating the eye-care company and cutting costs. Indeed, Valeant is expected to reduce Bausch & Lomb's workforce by up to 15% going forward, while it seeks to expand internationally.

In a sense, Cooper's growth prospects (single-use, silicone hydrogel and international expansion) are nicely mirrored in what its rivals are saying too.

Cooper's bumpy growth
While Cooper's prospects look assured, the growth ahead won't be in a straight line. For example, management was very clear on the conference call that it was willing to invest in building out capacity for the growth of MyDay. According to CEO Robert Weiss:

 it is unlikely we will be making profits on MyDay in the next several years with the intent of continuing to develop that franchise, continuing to drive down cost of goods... ...capacity increases behind the product once we come to the U.S. and then... ...other markets around the world

Ultimately, it's not clear how this will affect profitability over the next few years. Moreover, international expansion comes at a cost, and Cooper predicts capital expenditures at a historical high of $200 million (nearly 12% of projected revenue) for next year.

A look at its historical performance demonstrates that Cooper can grow revenue in a recession (note its 2008-2010 performance) and its adjusted free-cash flow (calculated by assuming capital expenditure is equivalent to depreciation) is quite strong.

Sources: Company presentations, author's estimates.

Time to buy Cooper Companies?
Cooper's aim is to hit 25% operating margins by 2018. Assuming it does so, and revenue grows at 7%, then operating income is likely to be $560 million or 71% higher than it is now. In other words, operating income looks set to grow in excess of 11% a year compounded.

That's not astonishingly cheap for a company generating around 4.4% of its enterprise value in adjusted free-cash flow. However, Cooper is a relatively recession-resistant company, and Foolish investors should be willing to pay a premium for this quality. It's a good stock for long-term investors, but don't expect the ride to be plain sailing all the way.

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