Cooper: Women Health Business Make Room For Growth; Path For Margin Expansion (NASDAQ:COO)

The Cooper Companies (NASDAQ:COO) has been quite successful in their core contact lens industry, experiencing high-single-digit growth. The company has been expanding into the women’s health business, with the CooperSurgical business mix increasing from 17% a decade ago to 32% of total revenue today. I believe their strategic business expansion makes sense, and they are on the right path for margin expansion. I am initiating a ‘Buy’ recommendation with a fair value of $415.

Contact Lens: Stable Growth in a Concentrated Market

In the vision care markets, the industry is highly concentrated, with only four leading players worldwide, as illustrated in the chart below. In the specific context of the contact lens market, which constitutes a total addressable market of approximately $10 billion, Cooper holds a significant position, accounting for around 23% of the total market share.

CooperVision has enjoyed robust revenue growth over the past two decades, averaging an annual growth rate of more than 8%, significantly outpacing the industry’s 5% growth rate. Several factors contribute to their success in the vision market.

The entire contact lens market is undergoing a shift from non-dailies to daily disposable products. Daily products offer various benefits for customers, including convenience, fewer concerns about lens care, enhanced comfort, and increased safety. Research and Market projects that the disposable contact lens markets to grow a CAGR of 9.27% during 2022-2027 period. Cooper’s MyDay daily disposable product has been highly successful in capturing a significant share of this rapidly growing market.

Furthermore, toric and multifocal lenses function like annuities. Once an optometrist prescribes toric or multifocal products to a patient, they are inclined to stick with the same brand in the future. For manufacturers like Cooper, this represents a consistent and recurring revenue stream.

CooperVision has delivered robust growth over the past two decades, as illustrated in the chart below, and the growth in the vision division has contributed to their success in the vision care industry.

Expanding into a Women Health Business

Cooper has deployed significant capital towards acquisitions to bolster its surgical business, offering a range of medical devices, including those in fertility, genomics, diagnostics, cryostorage, and contraception. CooperSurgical’s contribution to total revenue has grown from 13.4% in FY05 to 32.5% in FY23.

It makes strategic sense for Cooper to expand its surgical business.

Firstly, according to Alcon’s (ALC) capital market day presentation, the entire contact lens market is only $10 billion in total, presenting a limited growth opportunity for Cooper. To achieve substantial growth, they must diversify into markets where they possess expertise.

Secondly, the women’s health industry is a niche market with fewer global players, making it comparatively easier for Cooper to scale.

Lastly, the global trend of delayed childbirth creates a structural growth driver for the women’s health market. According to the BMC report, the proportion of women who delay childbearing until or beyond 30 years has dramatically increased in the last three decades. The trend has generated a huge potential market for fertility, genomics, diagnostics, cryostorage, contraception, etc.

In short, Cooper’s expansion into women’s health could add another growth leg for the company and expand their total addressable market size.

Historical M&A Created Margin Pressure

Cooper is actively pursuing bolt-on acquisitions to expand their women’s health business. For example, in 2022, they acquired Cook Medical’s Reproductive Health business, a manufacturer of minimally invasive medical devices focused on the fertility, obstetrics, and gynecology markets, for $875.0 million. In 2021, they acquired Generate Life Sciences, a privately held leading provider of donor egg and sperm for fertility treatments, for $1.663 billion.

These acquisitions helped them scale up their women’s health business segment; however, these strategic acquisitions have impacted their near-term margins. The adjusted operating margin declined from 28% in FY19 to 24% in FY23, contributing to a decrease in their stock price in recent years.

I believe their weak stock price in the past few years was caused by the lack of margin expansion; however, I believe their margin will start to improve in the coming years. When CooperSurgical grows to a certain size, there will be a tipping point when the operating leverage exceeds the margin impact from acquisitions. At that point, the group-level margin should start to benefit from the operating leverage driven by high-single-digit topline growth and mid-single-digit operating expense growth. In their FY24 guidance, the adjusted EPS growth is forecasted to grow by 7.7%, even considering the negative impact from the contact lens shortage. As such, I think they are on the right track for margin expansion.

Financial Analysis and FY24 Outlook

During Q4 FY23, Cooper achieved impressive results, with a 10% growth in organic revenue and a remarkable 26% increase in adjusted EPS. Notably, their vision business experienced an 11% organic growth, while the surgical business saw a 7% year-over-year increase. For FY24, they anticipate organic revenue growth in the range of 6-8%, and I believe they are positioned to deliver at the high end of this guidance, aligning with their historical growth trend.

During the Q4 FY23 earnings call, the management highlighted that the strong quarter’s growth was fueled by robust demand for daily silicone hydrogel contact lenses in the Vision division and the fertility business in CooperSurgical. Sales of Cooper’s MyDay daily disposable product are experiencing significant demand, leading to an expansion of manufacturing capabilities to meet this increasing market need. Consequently, their capital expenditure rose from $242 million in FY22 to $393 million in FY23.

During the earnings call, it was highlighted that CooperVision’s business growth is currently constrained by manufacturing capacities, particularly in Q1 FY24. Consequently, they anticipate a 7% growth for their vision business in the first quarter. However, with the ramp-up of new manufacturing lines, they expect organic revenue growth for the vision business to accelerate throughout FY24. Additionally, they project a 2%-3% price increase for their vision business, consistent with the normal price increase pattern observed in the past.

On the margin side, their adjusted EPS only grew 3.1% year over year in FY23, and they are guiding for a 7.7% of EPS growth in FY24 at the mid-point. Many questions regarding margin expansion were raised during the earnings call. The management indicated that contact lens capacity constraints have had a negative impact on their margin guidance.

Cooper is set to announce its Q1 FY24 earnings on February 29th after the market closes, and I believe they are more likely to uphold their full-year guidance for several reasons. Their current full-year guidance has already taken into account the impact of contact lens manufacturing constraints, with most of the effect expected to be reflected in the Q1 FY24 results. Furthermore, the company is in the process of scaling up its new manufacturing lines, and the growth rate is anticipated to accelerate from Q2 FY24 onwards. Additionally, they should be positioned to achieve some margin expansion through the integration of their historical acquisitions, pricing increases, and operating leverage. In summary, I find their full-year guidance to be quite achievable.

The table below outlines their financial performance over the past five years, revealing the negative impact of past acquisitions on their operating margins. The free cash flow margin shows fluctuations, primarily due to the expansion of disposable contact lens manufacturing facilities. Additionally, past acquisitions have introduced variability in their free cash flow margins. Almost all cash from operations has been directed towards capital expenditure and acquisitions, strategically building up their women’s health business.

Their balance sheet is reasonably sound, with gross debt leverage below 3x. In summary, over the past five years, their profitability and free cash flow growth have been relatively weak, despite solid topline growth.

Valuations

I anticipate they can achieve 8% organic revenue growth in FY24, in line with their guidance, implying some sales growth impact from a contact lens supply issue. The model is assuming 9.5% normalized sales growth in the coming years, aligning with their historical trend. Regarding margins, I expect expansion over time as they capitalize on operating leverage and synergies from past acquisitions.

The model utilizes a 10% discount rate, 5% terminal growth, and a 15% tax rate. I apply the same WACC to all of my DCF valuations, and I believe Cooper should be able to grow faster than the overall GDP growth when the company reaches the maturity of its business cycle. Therefore, a 5% terminal growth is assumed here. According to my calculations, the fair value is estimated to be $415 per share.

Key Risks

Capital Intensive Business: The contact lens business is inherently capital-intensive, requiring substantial investments in massive manufacturing lines, particularly for high-volume products like daily disposables. Cooper has consistently allocated over 10% of their total sales to capital expenditure. I believe that as they expand further into the surgical business, the capital expenditure ratio is likely to decline over time.

Private Label Contact Lens: There are numerous private label contact lens products in the market, with notable examples such as Costco (COST) offering their own private label contact lens. Additionally, online players like 1800contacts sell affordable contact lens products over the internet. While these private label options may cater to customers seeking budget-friendly solutions, I believe that in the mid-end and high-end markets, these competitors may struggle to compete against global manufacturers like Cooper. The latter possesses strong brand recognition, robust research and development capabilities, and large-scale manufacturing capabilities that provide a competitive edge.

Conclusion

I like Cooper’s high-single-digit growth in their core contact lens market, and their expansion into the women’s health business makes sense. I am initiating a ‘Buy’ recommendation with a fair value of $415.