Description

Cooper is predominantly a contact lens manufacturer (+80% of total revs & profits), which is represents a sticky annuity type business as the average customer life ranges from 5-7 years. Given the highly sensitive nature of this personal care product (people are discriminant about what they put in their eyes), the category is not susceptible to being outsourced to low cost manufacturing centers like China.

Lots of Ways to Win:

Top line story, margin story, market share story, merger integration story and strategic value story. I think of this similar to personal care company, but with less discretionary characteristics and better growth.

Industry Structure:

With industry growth expected to increase slightly f/ MSD rate seen over the last 5 yrs. COO should be able to continue to outpace that rate (maybe double). It should be noted that none of this growth is predicated on an increase in prescriptions:

COO has a #3 market share overall, but is the only dedicated manufacturer and has #1 share in fastest growing segments.

3 secular mix shifts taking place in the industry—all skew favorably to COO:

• Materials mix shift—CVI lagging the industry in silicone hydrogel mix and playing catch up

  • SiHy lenses sell for a 30-40% premium to silicone lenses. As such, our math indicates that every 5% of mix shift (on flat prescription volumes) drives 1.5-2% of incremental $ sales

  • The market is ~80% penetrated by SiHy versus ~60% for Cooper

• Lens mix shift—toric (astigmatism) and multifocal lenses are growing faster than the industry; CVI has greater expertise and market share here

  • Technological advancements allow for more technical lens shaping/fitting thus expanding the addressable market

• Modality mix shift—daily lenses are underpenetrated in the Americas relative to the rest of the world; Dalies typically cost 4-6x more than the average lens

  • Sauflon acquisition puts them in pole position daily SiHy lenses—fastest growing part of the market

Sauflon Acquisition and New Market Positioning:

As mentioned, COO is the #3 player w/ 21% share, with a real chance to jump Alcon/CIBA (26% share) and move into the #2 position over the next few yrs.

• Mgmt. said 30% global share is in their line of sight (JNJ is @ 41%)

Global market growth expected to be 6% over the next 5 years. COO has outpaced the market’s growth by 1.5-2.0x over the last few years. This is in part due to their history as a specialty lens manufacturer which has given them a leg up in both toric and multifocal lenses:

• Overall market growth: 6%; COO position: #3

• Toric market growth: 8%; COO position #1

• Multifocal market growth: 10%; COO position #1

• Spherical market growth 5%; COO position #3

That’s why this Sauflon acquisition is such a game changer. Given that spherical lenses represent 71% of the global contact lens change of any sort starts first in this category. The acquisition should enable COO to take meaningful share in spheres:

• Dailies growth: 9%; COO position #3

• Daily SiHy growth: 20% COO position #2 (and JNJ is faltering as the leader here)

Moreover, COO is the only company in the industry that offers a full product suite of daily SiHys (spheres, torics and multifocals) and they have a 2-3 year lead over the competition. This gives them a huge selling advantage as a one-stop shop for practitioners. This is all in addition to the widely held consumer view that the company makes the most comfortable lenses.

Combined these things should lead to HSD/LDD annualized revenue growth through 2018. Moreover, dailies typically carry an ASP that is 4-6x higher than the average lens. This leads to huge operating leverage: management has laid out the path to 30% operating margins, up from ~24% this year.

• Beyond their head start on the product cycle, COO likely has a structural cost advantage. Post closing management discovered that Sauflon has found a way to remove alchohol from the manufacturing process, which is one of the most expensive input costs

• As such Sauflon’s lines cost ~$10m to build vs. the industry average of closer to ~$50m

• This also increases the flexibility of the line, whereby it can be reconfigured to manufacture new products with just 4 months of downtime. This compares to the industry standard of 18 months

  • Therefore, even if/when competitors do catch up, COO will have a structurally lower cost base/pricing advantage

Margin Runway:

• Royalties: prior to 2013, Cooper paid an 8% royalty to CIBA Vision on all sales of SiHy products before being lowered to an estimated 5%. This revised royalty rate will remain until CIBA's patents expire in the U.S. in September 2014 and outside the U.S. in March 2016

  • Estimated royalties could be ~$35m in sales or 2.5pts of margin opportunity on the pre-Sauflon #’s

• Operating leverage: new product maturation curves offer built in margin tailwinds as volumes scale

• Daily SiHy’s: gross margin dilutive, but sell for a 4-6x markup vs. avg. lens so operating margin accretive over time

• Sauflon Manufacturing: structurally lower cost; no alcohol used, lower startup costs and more flexible

• Cost Saves at Sauflon: nobody focused here, but could be big—Sauflon was spending a lot of money to ramp distribution in the US that goes away; tax savings f/ transferring IP to Ireland

Strategic Value:

#3 player, but only dedicated lens manufacturer—singular focus gives them an advantage in terms of faster product innovation cycles.

VRX: At a conference in London in November, management was asked what its next target opportunities theoretically might look like with AGN no longer an option. VRX indicated that it is interested in eye care and may look to bolster its contact lens business. For instance, management feels that one of the “gaps” in its eye care portfolio is its lack of silicone hydrogel lenses.”

I personally don’t believe the company is for sale, but think it could turn into a bidding war if somebody makes a move—Essilor is also rumored.

Cooper Surgical; (<20% of Sales):

CSl markets products that are used primarily by obstetricians and gynecologists in the office, surgical and fertility settings. Basically a roll up story as they consolidate a super fragmented industry and try to become one-stop shop for practitioners.

Other:

Discomfort is the biggest reason for patient dropouts from contact lenses. However, new technologies and materials (SiHy) were leading to increased comfort and helping to lower that drop rate. These advancements should further extend the age range of contact lenses wearers, both at the low and high ends and act as a driver to industry revenue.

COO is widely viewed as making the most comfortable contact lenses. This is in part due to their heritage as a specialty lens manufacturer. In short, COO’s lenses have higher silicone content which allows for increased oxygen flow to the eye, thus increasing comfort. This is competitive advantage since the manufacturing process is more technical and costs more. COO has figured out how to do this at scale in a cost efficient manner.

Valuation:

While you can never be 100% certain, it feels as if earnings were significantly de-risked on the most recent call. The street was braced for $0.30-0.40 of FX related headwinds but management took it a few steps further guiding down $0.90 at the midpoint. They reiterated that the entirety of the guide down was FX related and that the Sauflon deal was tracking ahead of their expectations. The discrepancy versus expectations was primarily related to the company not having manufacturing assets in certain geographies like Japan, which would have helped mitigate the FX impact by lowering costs. Instead the company bears the full brunt of the revenue headwind without any mitigating factors.

Within a year the path to $10+ in EPS will be clear so at 20x I conservatively get to a $200 target. Based on where other staples/personal care companies trade 20x feels entirely reasonable if not downright low considering the superior growth profile, multitude of self help margin drivers and sticky customer dynamics.

Catalyst

Earnings announcements.