COO

Business Context and Reporting Period

Company: The Cooper Companies, Inc.
Filing Type: Form 10-Q (Quarterly Report)
Period Ended: April 30, 2005 (Second Quarter of Fiscal Year 2005)
Business Overview: Cooper operates two primary segments: CooperVision (CVI), a global manufacturer of contact lenses, and CooperSurgical (CSI), a manufacturer of medical devices for women's healthcare. The reporting period is significantly impacted by the acquisition of Ocular Sciences, Inc. on January 6, 2005, for approximately $1.2 billion.

Key Financial Metrics

Material Changes vs. Prior Period

• Revenue Growth: Net sales increased 79% in the quarter and 58% year-to-date, primarily driven by the inclusion of Ocular Sciences' results since the January 6 acquisition date. CVI sales grew 99% in the quarter; CSI sales grew 4%.
• Margin Compression: Gross margin decreased to 61% from 65% (quarter) and 64% (year-to-date). This decline is attributed to a $7.5 million inventory step-up adjustment (writing off acquired manufacturing profit) and restructuring costs.
• Increased Leverage: Total debt surged from $165.7 million to $719.6 million to fund the Ocular acquisition. Interest expense increased 443% in the quarter and 296% year-to-date.
• EPS Dilution: While net income increased, diluted EPS for the six-month period decreased slightly to $1.11 from $1.13 due to a 21% increase in the weighted average number of shares outstanding (including shares issued for the acquisition).
• Balance Sheet Expansion: Total assets more than doubled to $2.16 billion, with goodwill increasing by $979.6 million due to the acquisition.

Guidance, Outlook, Risks, and Unusual Items

Management Commentary and Outlook

• Integration: Cooper is integrating Ocular to optimize synergies, with restructuring costs estimated at $25-$30 million over the integration period (through 2007).
• Capital Expenditures: Expected to be $115-$125 million for fiscal 2005, focused on manufacturing capacity and IT systems.
• Liquidity: Management expects operating cash flow and a $142.9 million available credit line to fund operations and smaller acquisitions.

Unusual Items and Risks

• Internal Control Material Weaknesses: The company identified two material weaknesses in internal controls over financial reporting:
  • Lack of expertise in applying SFAS 133 (Derivatives) regarding interest rate swaps entered in January 2005.
  • A senior manager failed to disclose that documentation for these swaps was not prepared contemporaneously with the transaction. The manager was terminated.
• Accounting Impact: Due to the documentation failure, $2.8 million of unrealized gains on interest rate swaps were recorded in "Other Income" rather than Other Comprehensive Income, impacting net income by $0.05 per share.
• Tax Litigation: The IRS has asserted a deficiency of $44.8 million in taxes plus $12.7 million in penalties against Ocular for years 1999-2001 regarding transfer pricing. Cooper intends to vigorously contest this.
• Inventory Step-Up: A one-time charge of $7.2 million (quarter) and $9.6 million (six months) related to the write-off of acquired inventory profit.

Investor Verification Checklist

• Acquisition Integration: Verify the progress of Ocular integration and whether the projected $25-$30 million in restructuring costs are being met.
• Internal Controls Remediation: Confirm that the material weaknesses regarding derivative accounting and documentation have been fully remediated and that future hedge accounting treatment is secured.
• Tax Litigation Outcome: Monitor the status of the IRS audit regarding Ocular's transfer pricing, as a loss could materially impact future tax provisions.
• Debt Covenants: Review compliance with the new $750 million credit facility covenants, specifically the debt-to-EBITDA ratios (currently 3.11:1) and fixed charge coverage.
• Margin Recovery: Assess whether gross margins can recover to historical levels once the one-time inventory step-up charges are fully amortized.