Note: This article was co-authored with Aamir Husain Kothari, who is a colleague and fellow Research Analyst at KIP Capital Management. I will always specify when on certain occasions he coauthors investment thesis that I put forth in the future. His email address is firstname.lastname@example.org.
Analyst note (October 2018)
We first began writing this investment thesis in April 2018. The price then was $225.12 - and the recommendation made was a NO-BUY. Since then, there has been one material change in the business - the acquisition of 'The LifeGlobal Group'.
(COO) stock price is now $274.5 - a 20% increase. Our recommendation stands. COO is a far more overvalued today than it was back in April 2018.
The Cooper Companies, Inc. (COO) consists of two disparate businesses in the medical devices industry. First, CooperVision ((CVI)) manufactures contact lenses, a product increasingly used by people requiring vision correction. Despite controlling almost a quarter of the global market, CVI fails to carve out a wide spread between ROIC & WACC for its owners. The second business, CooperSurgical ((CSI)), itself has two units - ob/gyn instruments and IVF processes. Both have a promising future based largely in developed nations, though CSI does not have a substantial moat in the face of fragmented and numerous competition.
Our process places PIE analysis (See Price-Implied-Expectations discussion below) ahead of valuation. The four scenarios presented in the PIE section show that both segments of COO are either fully valued or grossly overvalued.
Despite our detailed analysis, we were unable to lay out high-conviction inputs for a DCF analysis. In this case, the conclusions drawn from PIE analysis are sufficient. We conclude that COO is a clear NO-BUY.
COO is in the medical specialties sector. It operates through two business units: CVI - making up 80% of total sales, and CSI - accounting for the remaining 20%.
CVI is among the largest contact lens ((CL)) manufacturers in the world - with over 50% of sales from non-U.S. geographies. The contact lens industry is oligopolistic, with four players controlling 96% of the global market. Johnson & Johnson (JNJ) is the largest at 40% market share, followed by Alcon Novartis (NOVN) controlling 24%, CVI with 23% and Bausch&Lomb Valeant (BVF) with 9%.
CSI develops and manufactures diagnostic and surgical instruments primarily for obstetricians and gynecologists, accounting for 46% of CSI’s sales. The remaining sales are specialized products and services for in- vitro-fertilization ((IVF)) process used in fertility.
Headquartered in Pleasanton, CA, Cooper Companies has more than 11,000 employees with products sold in over 100 countries.
COO is in a later stage of high innovation in its competitive life cycle. Over the past 10 years, COO reinvested a large portion of its NOPAT to maintain an acquisitive growth strategy. It generated a modest FCFF, which was returned to owners mostly in the form of buybacks. Both industries (contact-lens & surgical-instruments) as a whole are expanding, and COO is likely to be a major player in both cases.
COO’s return on invested capital has been approximately 8% over the past 5 years and stable. Given a WACC of 8%, COO is earning a return equal to its cost of capital. The business is nevertheless in a high sales-growth period driven by large and frequent acquisitions. COO’s eight-year return on incremental invested capital (ROIIC) is healthier at 14%. This is indicative of some operating leverage and capital efficiency that may translate to a higher ROIC over the next 10 years.
Industry, economics & consumer behavior
The contact lens CL industry is at the ‘emerging’ stage in its lifecycle - with significant room for product innovation. Porter’s Five Forces analysis shows that CVI’s suppliers are providers of polymers and monomers for the production of lenses. Given their fragmented nature, suppliers’ leverage is low. Increases in supplier prices are likely passed on to customers. Eyeglasses are the only notable substitute to CL. In addition to being a much older technology, eyeglasses are cheaper and less complex. Other substitutes include intraocular and Lasik procedures - which pose little threat given their high cost and low availability.
’Comfort’ is the most important switch cost when a customer considers a brand of CL. Even so, opticians note that loyalty is rare and customers may switch between brands without compromising comfort.
The CL industry as a whole is featured with multiple sets of Barriers to Entry. The first is a set of health regulations enforced by governments. As ‘medical devices’ contact lenses are subject to enormous red tape and undergo rigorous testing before new products are permitted to be sold. The second is capital intensity. Manufacturing contact lenses is expensive and complicated. The process demands specialized equipment and trained personnel employing a learning curve. Lastly, 10 years of GAAP data shows that scale allows for cost advantages and improves profitability - so that new entrants may suffer years of losses before scaling up. Together, these barriers deter new competition.
The exception may be a company offering a niche product. Furnished with a unique technology and protected by a patent - a niche competitor may carve out a small, esoteric market for specialized CL. The reaction of large incumbents would likely be to acquire this player - since acquisitions are common practice in the industry.Incumbents in the CL industry are continuously trying to differentiate their product by adding incremental improvements to the products. From softness to ‘wettability’, firms perform R&D to better customer experience. Although incumbents try to eke out an edge with finer technological upgrades with patent protection, no single firm has substantial pricing power.
The industry is expected to grow as the incidence of myopia and the a growing middle class in emerging economies are on the rise. Industry growth estimates vary, but the expected range is 6-9% YOY for the next 5 years according COO’s quarterly investor presentation and trade journal Contact Lens Spectrum.
Lastly, the CL industry is not vulnerable to disruptive innovation in the next decade - as substitute solutions such an intraocular lenses and Lasik surgery are prohibitively expensive and not widely available.
With 23% global market share, CVI is renowned for producing high-quality CL of a wide range of modalities and parameters. Even so, a prominent market share and scale advantages have not translated to outsized returns on capital for CVI. Estimated ROIC of CVI has averaged at 10% over the past five years. This could be partly due to a poor relative market share. Cost advantages obtained from scale are shared with CVI’s major competitors.
Marketing may create some brand-based trust, but similar to pharmaceuticals, end-consumers place much trust in eye-care professionals acting as middlemen. Lens-wearers seek their recommendations on product, price, insurance and rebates.
There is a global rise in the incidence of myopia - the most common of all vision related disorders. More complex disorders including astigmatism and presbyopia are also on the rise. Researchers attribute this trend to an increasing share of the world living in urban spaces, with a majority of time spent indoors. They claim this may lead to myopia due to limited sun exposure.
The most important function served by contact lenses is cosmetic. Customers choose CL believing they look better in them than eyeglasses. Other functions include conveniences related to weather (better visibility during rainfall or high-humidity) and prescription-free sunglasses.
There is a pharmaceutical-like format in CL manufacturing. CL technology requires ample research and must meet enormous hurdles placed by FDA and similar state departments in every country. CVI’s buyers are eye-care medical practitioners - including ophthalmologists and opticians. These professionals are well-informed and understand the nuances of CL. End-consumers (especially new users) must heed the advice of their eye-doctors/opticians when choosing brand and lens-type. Eye-doctors and opticians are likely to choose established and trusted brands for their customers - further enhancing barriers-to-entry in the CL business. CVI’s brand would take many decades and significant investment to replicate.
For most users, contact lenses are a discretionary purchase. All vision correction done by CL can be achieved using eyeglasses, and often more cheaply with the latter.
Compliance is a big factor when using CL. The three modalities are daily disposables, bi-weekly and monthly. As the the duration lengthens, the CL require more care and maintanence. Eye-care professionals report that extended-use (biweekly and monthly) have poor compliance rates. On the other hand, daily disposables require almost no maintanence (unpack>wear>dispose) and are used most optimally by customers. Practitioners find that a large share of monthly and bi-weekly customers are not facetious about the necessary maintanence. Daily disposables are easiest to use but sell at a much higher price point.
Most customers use CL in combination with eyeglasses. Many find it cost effective to use eyeglasses for frequent use (work, school), and wear CL for special occasions. Daily disposables are ideally suited for this type of usage. A fresh set of lenses is healthiest for the eyes and requires practically no maintanence. COO forecasts daily disposables to be the fastest growing modality.
COO’s R&D expenses average at about 3% of sales and are an important feature of the business. The industry continually makes incremental improvements to the quality and comfort of lenses, however radical changes in technology are infrequent. For instance, the first soft hydrogel CL was invented in the early 70s, followed by the breakthrough silicon hydrogel ((SiHy)) lens introduced in the late 80s.
Local opticians admitted to us in an inteview that many users still find CLs uncomfortable. SiHy, despite being technically superior, is not for everyone. There is much room for innovation, they say, and customers report that comfort takes precedence over all else.
CL production is a slow and asset-intensive process. Inventory management is therefore crucial to CL manufacturers. The top four firms typically analyze the market to identify the most common eye-disorders and prescriptions. Manufacturers use this data to produce and store large inventory of CL. This helps lower the response time between manufacturing and over-the-counter sales. The downside is that manufacturers must maintain significant inventory, employ more working capital and a slow cash conversion cycle ((CCC)) of ~200 days in 2017.
Among the risks faced by CVI, there are two that would inflict most damage to the business. First, a major call-back of a CVI product due to eye-health issues. Second, a competitor inventing a production method that radically lowers cost, ultimately leading to increased market share by price undercutting. Given the absence of switch cost, customers would welcome lower prices. In terms of probability, neither risk is very likely given the stringent FDA testing on health implications and cutting-edge in-house research undertaken by every major CL manufacturer.
The IVF and surgical instruments sub-industries are in early stages of emerging, as researchers introduce unprecedented technologies and the ob/gyn medical community faces new challenges. CooperSurgical is in the market of family health care with a concentration in women’ s health. It develops and manufactures diagnostic and surgical instruments primarily for ob/gyns, and specializes in products and services in-vitro fertilization (IVF) process used in fertility. CSI collaborates with clinicians to identify new technologies to bring to the market.
Unlike the contact lens market, the surgical instruments industry is fragmented and intensely competitive. Some of the leading players, apart from CooperSurgical, include Medtronic (MDT), Richard Wolf, Hologic (HOLX), Boston Scientific (BSX), Stryker (SYK), Karl Storz, and Ethicon (JNJ).
Industry reports as well as COO’s 10K indicate that the market expects ample growth in the future - driven by the growing preference among patients for minimally invasive surgeries ((MIS)). Faster recovery time, decreased hospital stay, and decreased postoperative pain are benefits of MIS. These methods are complicated and require specialized robotic technologies - the use of which is expected to drive the surgical instruments industry in the future. The estimated size of the industry was $7.6b in 2016, and is expected to grow at a CAGR of 15% until 2022.
The rising incidence of gynecological diseases, increasing awareness, and soaring government investments focused on women’s health are also factors stimulating demand. North America and Europe are the prominent markets for the industry. Countries such as India, China, and Japan are expected to witness significant demand attributed to improvement in healthcare services.
CooperSurgical expects patient visits to ob/gyns in the US to increase over the next decade. Driving this is a growing population of women over 65, a large and stable middle-aged population, and a steady number of reproductive age women with increasing fertility issues as well as women interested in reversible contraception. CSI expects growth in fertility treatments as more women choose to delay childbearing to the mid-thirties and beyond.
The global IVF market size was estimated at $14b in 2016 and is expected to grow at a CAGR of 10% until 2022. Increase in cases of infertility and development of advanced technologies are two major demand-drivers. The largest market for IVF is Europe, followed by Asia-Pacific and North America. Regulatory landscape is changing within developing nations and this could mean a large influx of foreign investment in the healthcare space.
Much like CooperVision, CSI’s strategy is to acquire new products and smaller technology-driven firms to expand its product lines and services. It is seeking to grow its presence in the‘ hospital and outpatient surgical procedure’ segment that is currently dominated by competitors including J&J, Boston Scientific (BSX), Olympus (7733:JP) and Medtronic (MDT).
Value creation using the
Berkshire Cow model
About the model: The Berkshire Cow attempts to approximate the economic value a business has created (or destroyed) for owners over the past 10 years. Change in BV/sh plus the cumulative cash returned to owners frequently makes a good proxy for economic value creation. We do not aim for precision - only an indication of the quality of the business.
The model indicates that COO has created value for its owners in the past 10 years. $1.00 of equity invested into Cooper in 2008 would now be worth $2.07, at a CAGR of 7.5%.
During this period COO’s BV/sh grew from $31.49 to $64.39. A cumulative of $436m was returned to shareholders, of which $403m done in the form of buybacks. For details see supporting document here: Berkshire-Cow (NYSE:COO).
’08-‘17 Financial performance overview
Cooper’s sales have doubled since 2008, while operating income has grown 3.5x. Margins have consistently improved over the years showing some evidence of cost management resulting from supply-side economies of scale. Cooper’s growth has partly been fueled by debt. In 2017, long-term debt (LTD) accounted for 27% of invested capital.
Note: in the first quarter of FY18 Cooper invested $1 billion to acquire PARAGARD, a company that makes the only 100% hormone-free intrauterine copper contraceptive (IUD). This buyout was largely supported by a billion dollar debt increase making LTD 43% of total invested capital.
Despite a stellar EBIT margin growth from 12% to 20% in 10 years and a contracting tax rate, ROIC figures have remained in the single-digits - just under 10% in FY17. DuPont analysis indicates this is resulting from a slow capital efficiency that has averaged at 0.5.
Since 2007, CooperSurgical sales have risen at 13% CAGR while CooperVision sales have grown at 8%. CSI has thus become a larger part of COO - from 16% of sales in 2009 to 22% today.
COO’s fastest growing geographic segment is Europe, where sales have grown at a 10.2% CAGR representing 35% of total revenue. In comparison, US sales have risen at an 8% CAGR accounting for 43% of revenue, and rest-of-the-world growing at 9.6% representing 22% of revenue. COO’s non-domestic sales will grow in the future, especially in the case of CooperVision as it moves further into untapped markets such as Eastern Europe, Asia Pacific and BRIC (Brazil, Russia, India and China).
COO’s fixed assets has consistently been ~80% of total assets over the last decade. This inherently makes it a business with a high degree of operating leverage (10 year median ~3), making EBIT sensitive to changes in revenue streams. A slight decrease in revenue would starkly decline operating income, thus raising Cooper’s risk profile as it makes it more vulnerable to economic and business cycle swings. Conversely, this is a perfect recipe to grow EBIT margins in times of rising revenue, which is precisely what Cooper has experienced over the last 10 years.
Does either business segment stand out?
CooperVision shows no clear sign of firm-specific moats. It does however enjoy two forms of industry-related deterrents. First, a host of barriers to entry discussed earlier, and second, cost advantages from supply-side economies of scale - limited to the four large incumbent players.
There is little evidence of pricing power among CL. A product comparison of the big four manufacturers shows that they price their lenses similarly. 6
Barriers to entry include time and capital required for obtaining government approvals, research & development leading to patents and trademarks, and capital intensive fixed assets with high asset-specificity.
Cost advantages include production know-how leading to improved cost efficiency and large scale production leading to lower unit cost boosting profitability. The latter advantage is observed in COO’s improving gross margins and declining SG&A margins.
CooperSurgical CSI shows no signs of sustainable competitive advantages. CSI operates in a fiercely competitive market with players larger and more established. Products must pass through stringent FDA approvals to be available on the market, making quality-based differentiation difficult. Product efficacy does not differ greatly from one surgical instrument to the next. This leveling nature of the industry does not allow for pricing power.
On the other hand, CSI attempts to differentiate using patents and niche technology. This is evident with their latest acquisition of PARAGARD - the only FDA approved hormone-free IUD since the 1980s. CSI management likely assumes that PARAGARD will continue to be one-of-a-kind for some time. We were unable to determine why competition has not managed to replicate the technology. It is conceivable that the uber-specialized nature of the niche does not warrant investment. Strict FDA-approvals may also serve as a barrier.
The PIE model uses DCF analysis to determine the market expectations embedded into the current price of COO. The two business units - CVI & CSI - are distinct enough to warrant separate PIE analysis.
COO last traded at ~$225. CVI constitutes to 78% of sales today, and 22% from CSI. The model assigns price expectations accordingly. In other words, each scenario of CVI reflects ~$176, and each scenario of CSI reflects ~$50.
Cooper Vision: $176 (78% of COO price)
The following fixed assumptions are based on our understanding of the contact lens business.
Time horizon of CAP (competitive-advantage-period): 10 years. CVI’s narrow moat allows for ten years of outsized earnings. Reinvestments, especially in the form of acquisitions, are critical for both segments of COO. Historically, the capital efficiency (▵Sales/▵InvestedCapital) has ranged from 0.5 to 0.55. This ratio improves to 0.59 in the wake of higher-priced daily disposables. Cash tax rate: 7% WACC of CAP period: 8% (close to the industry average cost-of-capital of medical devices, and considering that CVI is operating increasingly in Asia-Pacific and MENA regions where country risk is higher) WACC Steady state: 8% Inflation/Risk-free-rate: 1.9% Operating leases (capitalized as debt): $137.5m Total debt (including Op Leases): $1.3b Cash: $46m
With the above assumptions fixed, changes in Sales growth & EBIT margin will reflect market expectations.
Since 2009, CVI sales growth CAGR has been 8%. EBIT margin has expanded from 15% (2009) to 25% (2017). The growth has been largely driven by acquisitions. Estimated segment ROIC has expanded from 7% to 12%.
CVI Scenario 1: Sales grow at 8% CAGR - to $3.7b in 2028. EBIT margin expands from 25% to 30%. ROIC rises from 15% to 17.5%, with▵sales/▵IC ratio at 0.59, and reinvestment of $3.4b. COO forecasts the global CL industry to grow at 6% y-o-y until 2022. Extrapolating this to 2028 would value the global CL market at $13.6b.
CVI sales of $3.7b would mean a 27% market share in 2028. We surmise that both the sales growth as well as EBIT margin in this scenario are optimistic but plausible.
CVI Scenario 2: Sales grow at 11% CAGR - to $4.8b in 2028. EBIT margin stays stable at the current level of 25%. ROIC remains stable at~15%, and reinvestment of $5.3b. The major flaw in this scenario is that $4.8b in sales implies that CVI controls 35% market share in 2028. Given the influence and financial strength of both J&J and Novartis, we think this is unlikely.
Cooper Surgical: $49.5 (22% of COO price)
The following fixed assumptions are based on our understanding of the medical instruments business.
Time horizon of CAP (competitive-advantage-period): 10 years. COO’s narrow moat allows for ten years of outsized earnings. Historically, the capital efficiency (Sales/InvestedCapital) has ranged from 0.5 to 0.55. This improves to 0.59 after the PARAGARD acquisition. Cash tax rate: 7% WACC of CAP period: 8% (close to the industry average cost-of-capital of medical devices) WACC Steady state: 8% Inflation/Risk-free-rate: 1.9% Operating leases (capitalized as debt): $137.5m Total debt (including Op Leases): $1.3b Cash: $46m
Since 2009, CSI sales growth has been 13%. EBIT margin has contracted from 23% (2009) to 13% (2017). The growth has been largely driven by acquisitions. Estimated segment ROIC has contracted from 14% to 6%.
CSI Scenario 1: Sales grow at 13% CAGR - to $1.78b in 2028. This is the rate CSI sales have grown in the past 10 years. EBIT margin expands from 13% to 33%. ROIC would rise from 5% to 17%, with▵sales/▵IC ratio at 0.59, and reinvestment of$2.1b. Although industry research points that both ob/gyn and IVF spaces have a bright future, there is only a small probability that CSI sales compound at historic rates. Importantly, It is highly unlikely that EBIT margin (currently declining) will skyrocket to 33%. Equally unlikely is that ROIC will balloon to 17%. The absence of a moat in CSI does not allow for such dazzling returns on capital.
CSI Scenario 2: Sales grow at 16% CAGR - to $2.3b in 2028. EBIT margin expands from 13% to 27%. ROIC rises from 5% to 15% - with reinvestment of just over $3b. This scenario is even more implausible than CSI’s scenario 1. COO’s balance sheet would be burdened with unparalleled amounts of debt to finance the acquisitions needed for such a breakneck growth. Doubly unlikely is doing so with EBIT margins expanding to 27% and ROIC growing to 15%.
Total Shareholder Return
CVI Scenario 1
Share count: 49
Price in 2028: $498
CVI Scenario 2
Share count: 49
Price in 2028: $548
CSI Scenario 1
Share count: 49
Price in 2028: $252
CSI Scenario 2
Share count: 49
Price in 2028: $275
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.