Pgiam/iStock via Getty Images Investment Summary Based on our recent top-down analysis, the healthcare sector offers around average value on a price/value-weighted basis when compared to the S&P 500 sector universe (Figure 1). The defensive nature of the sector has its utility in certain market conditions (like the 2022 inflation/rates market) but can be a drag on equity performance in trending markets. The Cooper Companies, Inc. (NASDAQ:COO) is a company that I know tremendously well having owned it periodically on and off over the years and covering it extensively here on Seeking Alpha. My latest publication (here) was revised to neutral and outlined the reasons why, but basically: (i) Solid fundamentals but high reinvestment required to achieve growth. (ii) Lack of cost differentiation means competitive position may be fading. (iii) In that vein, management is not investing retained earnings at rates higher than what we as investors could generally achieve elsewhere. Based on the recent developments in the investment debate, my rating is unchanged on COO at hold. I have made extensive updates to my modelling and forward projections which I share here today. Despite 1) the company’s recent numbers, 2) the recent pullback since March, and 3) the improving growth/profitability profile, there isn’t enough flesh to put on the skeleton at 26x forward earnings in my view. Rate hold on grounds of valuation and fundamentals. Figure 1. Author, using data from Bloomberg Q1 FY 2024 earnings breakdown 1. Key insights The company put up record revenues of $943 million, an 8% year-over-year increase (note: it posted Q1 earnings in May). It pulled this to earnings of $0.85 per share [non-GAAP]. The divisional breakdown on the top line is as follows: CooperVision, the larger of the two segments clipped record quarterly revenues of $636 million, up 11% year over year. Growth was underscored by 1) upsides in its daily silicone hydrogel portfolio, and 2) international strength [Americas +10%, EMEA +14%, APAC +7%]. and 3) product growth – torics and multifocals combined to grow 12%, and spheres were up 9%, daily silicone hydrogel lenses, MyDay and Clariti, up 18%; MiSight up 39%. The international revenue exposure is a standout in the debate and something COO has going for it in my view. Should the US enter a recession, those companies with heavy international revenue exposure are hedged to this event. CooperSurgical posted revenues of $307 million, up 400 basis points year over year. The segment faced challenges in Q1 with shipping interruptions due to a systems upgrade, which management said impacted the turnover of its medical device and fertility inventories. Despite this, Paragard sales were up 22%, and the fertility division’s sales were up 4%. Moving down the P&L, it saw ~20 basis points gross margin decompression to 67.3%, on operating margins of 23.8%. It threw off the free cash flow of $37 million following 1) CapEx of $74 million, and 2) net debt payment down to $2.6 billion. 2. Guidance Management views sales momentum in the backend of FY 2024 and has increased its full-year guidance of top-line revenues to $3.86 billion-$3.9 billion. This calls for 7.5%-8.5% year-over-year growth. Most of the change was from CooperVision [guidance increased to $2.59 billion-$2.61 billion, +8.5%-9.5%]. No change was made to CooperSurgical’s guidance[+5%-7%, calling for $1.27 billion-$1.29 billion]. It is eyeing earnings growth of 11-13% to $3.54 to $3.60 per share on this. There’s no denying it was a strong quarter of business growth for the company. Product sales in its CooperVision business are gaining traction, culminating in accelerated top-line growth for the company. For instance, the company’s 3-year annualized revenue growth rate is 11.95%, against a 5-year CAGR of 7.5%, and a 10-year rate of 8.5%. All of these are positive data points that cannot be ignored. They signal 1) a company doing good business, 2) expanding product sales, 3) market uptake of the company’s products, and 4) being this is in the medical/health care domain, is likely making somewhat of a difference. The issue I have here though is twofold. For one, not all growth creates economic value. And two, the price to participate matters a lot. Updates to modelling and valuation 1. Business returns First principles thinking is required to explain the difficulties I see COO stock has in trading back to its former highs. A central tenet to equity investment is obtaining a proper recovery of your asset, including 1) capital, and 2) return on capital. When you buy stock of a company in the marketplace, you purchase $”X”/share of capital that’s been “injected” into the business (invested capital per share), which produces $”Y”/share in post-tax earnings (return on invested capital). What YOU pay for the capital (i.e., the multiple) must also be indexed against a required rate of return, representing the next best opportunity at a similar level of risk. COO’s pre-tax ROIC has been contracting on aggregate since 2021, where it topped 11.7% in the 12 months to September ’21 (Figure 2). Despite reasonable sales growth, as discussed earlier, this has required substantial capital reinvestment to engender. So whilst sales have compounded at ~12% each year from 2021-’23, when put against the investment required to produce it, the returns have actually decreased over this time. This is a trend that needs reversing – quickly – if there’s to be a substantial change in investor sentiment. You’ve got the stock priced at 36x trailing EBIT as I write, 58% premium to the entire healthcare sector, for <10% pre-tax profits on capital employed. Figure 2. Company filings Previously, the company’s business returns had been a standout in the debate. But these have dwindled as it lost its short-term competitive advantages gained throughout COVID-19 and invested heavily in acquisitions and operating efficiency. Shown below is the erosion of shareholder value visualized in one series (Figure 3). The following notes are relevant: Management invested an additional $10.46/share of funds into the business to produce an incremental $0.37 in NOPAT/share from 2021-2024 (trailing 12 months basis). This is a 3.6% increase in earnings power/incremental ROIC. Investors continue to pay ~2x EV/IC and ~30x NOPAT for the company today. However, it has been all multiple contraction over the last 3 years (2.6x – 2.1x). The market return on capital (analogous to earnings yield) implies that earnings power is low. A $1 investment buys just $0.03 in earnings under these stipulations. Alas, the situation is 1) capital higher, 2) earnings flat, 3) multiples contracting, and 4) little value (earnings power) at current prices. In my view, this supports a reiterated hold rating. Figure 3. Company filings, author 2. Updates to projections Consensus projects ~10% growth in EBIT off 8% revenue growth this year, calling for $1.36 billion and $4.4 billion respectively. In my opinion, these are overly optimistic projections due to 1) ongoing capacity constraints in the silicone hydrogel portfolio [MyDay, Clariti, and Biofinity lenses], 2) investments to address this [expanding product lines] will take time to pull through, and 3) management’s view on FY 2024 on the last earnings call [it looks to <$4 billion in sales this year]. If COO continues at its steady state of operations (that is, a similar pattern to its last 3 years) my revised numbers produce ~$4 billion in sales for FY 2024, but only $861 million in pre-tax earnings, stretching up to ~$1 billion around 12 months later. This is down by ~$500 million from previously [see: previous COO publication]. I have wound back my estimates on ROIC as well and now see free cash flow production of $300 million-$350 million over the next two years respectively. This has implications for my views on valuation as discussed below. Figure 4. Author’s estimates Valuation If ever there were a case to buy the stock today it would all fall at the seams given the exorbitant multiples it is priced at. You are asked to pay 55x GAAP earnings (26x non-GAAP) and 36x trailing pre-tax income. This translates to 2.4 times the net assets employed in the company only to receive a return on equity of 4.5% – nearly 40 percentage points below the sector. Paying that multiple investor return and equity reduces to almost 2%. Projecting my revised estimates of free cash flow out over the coming decade and discounting them back at a 12% right (reflecting long-term market averages) I get to a valuation of $61 per share. This could increase to $91 per share if management continues deploying capital at the current rate of return. Figure 5. Author’s estimates Over the last three years the multiple investors have paid on invested capital has contracted sharply, as discussed earlier. It now trades at its lowest levels in around two years. Figure 6. Company filings, author It is also priced at 47x trailing NOPAT which is quite expensive in my opinion. The reason for that is shown below. I’m going to be very generous with the company by awarding it a 40x multiple on my forward estimates, and 2.6x on estimates of invested capital (Figure 7). Even being this generous doesn’t get to where we need to in valuation, and implies the company is worth around about where it trades as I write. This further supports a neutral view. Figure 7. Author’s estimates Finally, I wanted to illustrate the process we go through in sizing up opportunities here at Bernard in analyzing earnings power. Say we bought 1000 shares of COO at the market today it would cost us $94,810. We would receive a little over $2,000 in earnings power (c.$2.03 NOPAT/share x 1,000 shares = ~$2,003), otherwise a 2.1% market return on capital. If it does hit the growth numbers stipulated it provides earnings power of $2,335 under the scenario, 15% growth. Figure 8. Author’s estimates Our position would grow to $109,175. However, this is entirely tied up to the multiple – what happens if the multiple contracts sharply? If it were to shoot down to say 25x (47% decline) the implied valuation is $58 – otherwise a 38% loss, with final capital of $58,380. My estimate is the company trades fairly on a 41x NOPAT multiple today (13% downside potential). This is further evidence of a neutral rating in my opinion. Figure 9. Author’s estimates In short COO’s business growth is commendable along with recent developments in its product portfolio. The company’s MiSight division continues to exhibit strength in product sales as well. From my perspective there are two issues to the debate here – 1) the economic value (and therefore shareholder value) is absent because any earnings growth is produced on tremendous amounts of investment, and 2) the market has priced the company to deliver this growth to perfection. As such, the stock is too hot at 26x forward earnings and >45x trailing NOPAT. I can’t advocate paying such a high price without the economic characteristics to back it up. Net-net, reiterate hold.
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