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At Cooper, Growth Is in Sight

By Cameron Lavey We at Standard & Poor's Equity Research Services believe that health-care products maker Cooper Cos. (COO

; recent price: $59) will continue to gain market share in each of its core product segments through product-line enhancements and extensions, geographic expansion, and strategic acquisitions. We expect favorable demographic trends and improved product technologies to drive double-digit revenue and earnings growth over the next several years. Given our view of promising growth potential and attractive valuation, the stock carries S&P's highest investment recommendation of 5 STARS, or buy.

Cooper develops, manufactures, and markets health-care products through two business units: CooperVision (CVI) and CooperSurgical (CSI). CVI (80% of fiscal year 2003 revenues) develops, manufactures, and markets a broad range of contact lenses for the worldwide vision-care market. It specializes in "toric" lenses that correct astigmatism, cosmetic lenses that change the appearance of the color of the eye, multifocal lenses designed to correct for presbyopia (an age-related vision defect resulting in difficulty seeing objects close up), and lenses for patients experiencing mild discomfort relating to dry eyes during lens wear.

CooperVision continues to grow faster than the worldwide contact-lens market due to what we see as its superior lens technologies and product mix. Cooper believes it's the only contact lens manufacturer to use three different manufacturing processes to produce its lenses: lathing, cast molding, and "Finished Inside Polymerization System" (FIPS), Cooper's patented process that's a cost-effective combination of lathing and cast molding.

SHIFTING FOCUS. During fiscal 2003 (ended October), CVI expanded its product offerings by making both Frequency Multifocal, a disposable product for patients with presbyopia, and Enhancement Colors, a disposable cosmetic product that enhances eye color, available worldwide. In addition, Rohto Pharmaceutical introduced CVI's line of frequently replaced spherical lenses in Japan. In the spring, CVI introduced its two-week disposable toric lenses in Japan and Proclear disposable multifocal in major European markets. We anticipate that the Proclear multifocals will be launched in North America by October.

We believe that several ongoing shifts in the global contact-lens market will benefit CVI, namely the moves from conventional lenses that are replaced annually to disposable and frequently replaced lenses; from commodity lenses to specialty lenses, including toric, cosmetic, and multifocal; and from commodity spherical lenses to value-added spherical lenses. All of these trends favor CVI's line of specialty lenses, in our opinion.

Moreover, we believe favorable demographics will help drive growth over the next several years. These trends, in our view, include the expansion of the teenage population in the U.S. (according to the 2000 Census), who are the prime wearers of contact lenses, and a higher incidence of myopia in teenagers (according to the Centers for Disease Control), resulting in increased purchases of specialty contact lenses.

INTERNATIONAL EYE. Cooper recently agreed to acquire Ocular Sciences (OCLR

; $44) for about $1.2 billion in cash and stock, subject to approvals. We believe that the acquisition is a good fit, as it's expected to broaden Cooper's product portfolio, geographic reach, and distribution channels.

We also expect significant cost synergies from the deal in areas such as research and development, manufacturing, and distribution. With Ocular generating most of its revenue from spherical lenses and CVI generating the majority of its revenue through specialty lenses, we believe that there will be minimal cannibalization of sales.

In addition, with the purchase of its Japanese distributor in April, 2002, Ocular gained a significant presence in Japan, the second largest and fastest-growing contact lens market in the world. As CVI generates less than 10% of contact lens sales in Japan, we view Ocular's presence in Japan as an important future driver of growth for CVI.

FRAGMENTED MARKET. Cooper's CSI unit (20% of fiscal 2003 revenues), develops, manufactures, and markets medical devices, diagnostic products, and surgical instruments and accessories used primarily in gynecologist and obstetrician practices. During fiscal 2003, CSI completed two acquisitions: Prism Enterprise, which develops medical devices and disposable products for the obstetric, neonatal, and gynecological markets; and Avalon Medical, the U.S. distributor of the Filshie Clip (a device used to perform female sterilization).

In fiscal 2004's first quarter, CSI acquired from SURx the rights to a product line to treat female stress incontinence. In the second quarter, CSI bought Milex Products, a manufacturer of obstetric and gynecologic products and services, for $26 million.

The medical-device segment of the women's health-care market is still highly fragmented, in our view. CSI has grown at a compound rate of 23% over the past five years, largely due to selective acquisitions. We anticipate that the pace of deals will continue, coupled with low double-digit organic growth, and that CSI will continue to show strong top-line growth due to the depth of its product offerings. In addition, as it integrates acquisitions and realizes additional synergies, we expect margins to widen.

SYNERGISTIC BOOST. We look for Cooper's revenues to grow about 20% in fiscal 2004, to about $493 million, on an 18% advance at CooperVision and a 25% increase at CooperSurgical. We see operating margins of 23% and EPS of $2.58. In fiscal 2005, we see revenues of approximately $936 million, which includes an estimated $378 million from Ocular Sciences, operating margins of 21%, and EPS of $3.30. As synergies from the Ocular acquisition are realized, we think that operating margins will return to prior levels and possibly trend slightly higher.

Based on Standard & Poor's Core Earnings methodology, we estimate S&P Core EPS of $2.42 for fiscal 2004 and $3.15 for fiscal 2005. Our S&P Core EPS estimates include stock-based compensation expenses of about $4.6 million in fiscal 2004 and $5.3 million in fiscal 2005. Our fiscal 2004 S&P Core estimate also excludes an asset sale gain of $1.4 million and a loss on a settlement dispute of $365,000. In our opinion, the divergence between Cooper's operating and S&P Core EPS estimates is in line with similar health-care products companies that we cover.

Our 12-month target price of $73 is supported by both our discounted cash-flow model and our peer-group analysis. We believe that Cooper will be able to meet our cash-flow growth assumptions as it increases market share and expands its geographic reach. Our discounted cash-flow model incorporates a weighted average cost of capital of 7%, 25% free cash flow growth in fiscal 2004 trending down to 4% in year 15, and terminal growth of 3%. Our target price implies that the stock will trade at about 22 times our fiscal 2005 EPS estimate of $3.30, resulting in a p-e-to-growth ratio of 1, below that of peers.

GAINING SHARE.Risks to our target price and recommendation include the potential complexities in integrating the Ocular acquisition, as well as the possibility that the cost synergies won't be as large as expected. In addition, Cooper faces significant competition in the contact-lens and women's health-care markets from several larger, well established manufacturers. Rivals have recently launched new products that compete with Cooper's specialty contact lenses.

Overall, we think Cooper will continue to gain market share in both its CooperVision and CooperSurgical business units. Favorable demographic trends and selective acquisitions should help drive sales and profit growth. The acquisition of Ocular Sciences will make Cooper the third-largest contact lens manufacturer, and we believe it could become the second-largest in the next few years. Given our view of promising growth prospects and attractive valuation, we recommend buying Cooper's shares. Analyst Lavey follows health-care products companies for Standard & Poor's Equity Research Services

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