Cooper (NYSE: COO ) , or more formally "The Cooper Companies" is a sort of odd duck in the med-tech world. It's fairly well-respected by eye care rivals like Johnson & Johnson (NYSE: JNJ ) and Novartis (NYSE: NVS ) ; it has done well in the market (up more than 280% over five years and about 55% over the past 12 months); and it's well-followed and well-owned on the Street.
Even so, it doesn't generate much pizzazz with individual investors, and there's not much coverage of it out there. Some of that may be due to valuation -- as Cooper rarely trades at a multiple I'd call cheap -- but this is a story likely to feature strong market share gains and meaningful margin/free cash flow leverage, and those tend to be the stocks that outperform.
A few steps forward, but at least one step back
Cooper had what I'd call a "mixed" fiscal third quarter.
Revenue rose 9% as reported, which was good for a slight beat relative to the average sell-side guess. CooperVision saw sales rise 9% (organic/constant currency), making up about 80% of the total, while CooperSurgical saw 6% organic growth on strength in its fertility products.
Margins were the dicey part. While Cooper did see gross margin improve 160 basis points annually, in part on the basis of lower royalty costs, that margin was 110 basis points lower sequentially and nearly a point lower than the Street was expecting. Operating income rose 15%, but again more had been expected, as the operating margin improved 230 basis points but missed the target by about half a point. Absent a boost from a lower-than-expected tax rate, Cooper would have missed by about $0.05 per share.
Good progress in vision
A large part of the reason to own Cooper is the company's prospect for taking even more share in the global contact lens market. Cooper has grown its share from about 16% in 2009 to around 19% in 2013, despite lagging in key areas like silicone hydrogel, or SiH, and dailies.
For this quarter, Cooper saw excellent growth from its SiH lenses -- up 22% on an organic basis. That's well ahead of industrywide growth in SiH, though it's important to note that Cooper is playing catch up here. Rivals like J&J and Novartis had a big head start on Cooper, and their businesses are more mature. Even so, it's an encouraging sign for the company's SiH Biofinity line, particularly as Bausch & Lomb's (now owned by Valeant) Biotrue line seems less impressive so far.
It should get even better from here. Cooper remains on track to launch its MyDay line of SiH daily contacts in the U.S. next year, and dailies are another area of relative weakness for the company. While the industry generates about 40% of its business from dailies, Cooper is at around 25%. Given that daily lenses can generate two to four times as much revenue as two-week or monthly lenses, that is a major opportunity for the company as its current dailies market share is only about 11%.
Surgical still offers multiple growth opportunities
Although it's overshadowed by the vision business, CooperSurgical has opportunities all its own. Not only does the company have a solid presence in ob/gyn surgical tools and instruments, but after the acquisition of Origio it also has about 40% share of the in vitro fertilization, or IVF, market.
I think the company can do better here over time. There are a lot of small med-tech companies in the women's health space that have good products but lack sufficient sales and distribution capabilities to leverage them. What's more, with the medical device tax meaningfully ratcheting up the effective net tax rate for these smaller, U.S.-focused companies, I don't think it's a stretch to say that there are opportunities out there.
Not unlike the company's exclusive distribution agreement with Utah Medical for the Filshie Clip, a surgical contraception device, I believe there are many other products or companies in the $10 million to $40 million a year range that Cooper could consider acquiring or licensing to better leverage its own sales infrastructure.
The bottom line
Revenue growth prospects here look strong, but that's only part of the story. Future reductions in royalty expenses, better manufacturing margins, and better operating leverage could all combine to deliver some significant margin leverage here, enough to vault the company into the low 20% range for free cash flow margin. With that, a long-term free cash flow growth rate of more than 10% is not out of line.
Unfortunately, none of this is lost on the Street, and these are not cheap shares today. It's difficult for me to get above a fair value of $115 on cash flow alone, though I do acknowledge that med-tech stories combining market share growth and margin leverage can go much higher than cash flow valuations would suggest. With that, I'd be in no rush to sell Cooper, but I might try to wait for a pullback before investing new money in it.
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