Coloplast

The Humlebæk, Denmark based company continues to gain ground on the complex and difficult North American market where there are great opportunities for growth. Management is driving this process by keeping a constant focus on doing things better each year. We view the somewhat surprising timing of a change in CEO as an undramatic event and consider it merely as a testimony to a successful succession.

In last year’s book we wrote about how the stock market was not rewarding Coloplast’s long-term values and strategic initiatives – but in 2018, the stock market’s view of this global market leader changed quite substantially.

This resulted in the share price, including dividends, appreciating by 26 percent in Danish kroner. Unlike the stock market, our positive view of Coloplast’s business opportunities hasn’t changed from last year. The reason being that we remain firmly convinced that the company is simply delivering on what it has always stated it was working towards.

When the annual report for the fiscal year 2018 (which ended on 30 September 2018) was presented, the major news for us was that Lars Rasmussen would be stepping down as CEO after ten years in that role. We are glad to see that he will remain involved in Coloplast’s development – now, as chairman of the board. We appreciate that the board has prioritised keeping all the detailed and strategic knowledge onboard, rather than simply “checking the box” for what is considered “good” corporate governance, where a CEO should not become chairman of the board so soon. It is also worth keeping in mind that two of Denmark’s great stock market success stories have been Topdanmark and DSV – companies which have let its departing CEOs carry on as chairman of its boards.

During Lars Rasmussen’s time as CEO, revenues in Coloplast has grown organically by around seven percent a year – which is extremely impressive, especially considering that market growth in the same period has been barely five percent.

 World-class performance under Lars Rasmussen’s guiding hand

Of course, growth is one thing – whether it is profitable growth is another matter.
Operating margins have increased significantly during the same period, and while Coloplast today has operating margins of more than 31 percent, the margin was a more modest 17 percent when the Board of Directors, headed by Michael Pram Rasmussen appointed Lars Rasmussen to be the new CEO ten years ago. During those ten years, revenues have increased from almost 8.5 billion Danish kroner to 16.5 billion, while annual operating income has grown from one billion to five billion. Earnings per share grew by an impressive 19 percent per year during this period. The return on invested capital has also increased from 10 percent to the current 44 percent. We find it fitting to call this value growth world-class, which is also reflected in the impressive rise in the share price which has grown by more than 26 percent a year in the period, including dividends. Michael Pram Rasmussen became chairman of the board in December 2005, and throughout this period he has had an extremely positive impact on the corporate culture by increasing the focus on value creation.

A well-executed succession plan

Having Lars Rasmussen as chairman of the board means that he will continue to be involved in the company and can act as a sparring partner for Kristian Villumsen who, after almost ten years with Coloplast, will take over as CEO. We view it as an indication of strong leadership, that the board had a clear plan for the succession, as this helps to ensure continuity and stability in the company – and it will also mean a continuation of the strategy already in progress.

Of those ten years Kristian Villumsen has been in Coloplast, he has spent the last four years as a member of the Executive Board, where he has been in charge of Coloplast’s chronic care business, which covers ostomy and continence, in addition to being in charge of the company’s Emerging Markets region. Chronic care represents about 75 percent of revenues and an even larger share of earnings. This is the core of Coloplast’s impressive value creation, where the return on invested capital for the group is at an impressive 44 percent.

Market shares in these markets do not generally shift much due to long-term customer relationships and – on some markets – due to long tender-awarded contract periods. Despite this, Coloplast has continually succeeded in gaining market share, and increasing market share is expected to continue through market-leading innovation in product development and a strong and focused corporate culture.

The global market for ostomy and continence products is a stable one, and it has a relatively predictable development that is supported by an ageing population with longer life expectancy. The customers are in the unfortunate position of suffering from chronic illnesses. Coloplast’s products aim to make the everyday lives of the customers easier, and – as long as the products are comfortable to use – customers generally remain faithful and loyal to the products. Thus, Coloplast’s objective is to get access as early as possible in the patient’s treatment, and ideally, Coloplast’s products should be the first that the patients are introduced to.

Complex purchasing structure at hospitals in the United States

As a rule, the European markets involve tenders, through which the manufacturers can win contracts with hospitals, regions, countries etc. Coloplast is the leading player in Europe.

On the important North American market, hospitals are part of purchasing organisations that use a similar process to select what manufacturers and products doctors and nurses will be able to choose from. However, unlike Europe, these are not exclusive contracts, and Coloplast can thus still gain market share via a strategic sales effort.

This means that even though Coloplast is, regrettably, not represented on the lists from the three primary purchasing organisations, it has still been possible to gain market share on the North American market. Over the last year, Coloplast has increased its investment budget significantly by almost two percent of revenue (amounting to around 250-300 million kroner) and it has been focusing on expanding and strengthening the sales organisation. This is done in order to accelerate the sales growth to reach the upper level of the company’s guidance of seven to nine percent organic revenue growth. There is after all not much value in having innovative products if the customers do not know they exist.

 Wrestling with the patients’ greatest fear

Coloplast has invested (and continues to invest) a larger proportion of the revenue in the development of products that doctors, and nurses can see an advantage in using. For ostomy patients, it goes without saying that their greatest fear is that a leak would occur. Therefore, leakage prevention is a very strong focus area for the ongoing development of this key product. Coloplast is working hard with regards to how integration of sensors and technology can be used to warn patients if there are circumstances that increase the risk of the ostomy bag leaking. Coloplast always aims to be a discrete helper – and therefore, in essence, Coloplast wants their products to be so good that the patients do not need to spend much time thinking about them.

In 2018 the innovation and development work led to Coloplast winning a contract with Cleveland Clinic. Besides handling almost five percent of ostomy surgeries in the United States, Cleveland Clinic is also viewed as an a key opinion leader – and this can lead to greater awareness of and trust in Coloplast actually supplying better products.

 Organic growth reached new heights in the latest fiscal year

Ostomy is the biggest business area for Coloplast and represents approximately 40 percent of revenue. Over the last few years, Coloplast has been focusing on launching its newly developed convex and concave products. These are ostomy bags that are designed to fit the body’s contours better. The aim here is, as mentioned, to be a discrete helper. Therefore, the products should adjust to fit the consumer’s body shapes as well as possible. Coloplast has had a successful launch of these products, and this has contributed to Coloplast managing to organically increase revenue by almost eight percent during the last fiscal year. The growth rate had been seven percent in the four previous years. Even though a single percentage point might not sound like much, it amounts to around 150 million kroner in additional revenue. This is quite a feat, and we view it as being a strong reason for last years’ strong share price development. As product loyalty is high, we regard this as being particularly attractive from a long-term value perspective, and incremental operating margin is assessed are assessed as being highly attractive due to significant economies of scale.

Besides the chronic care, Coloplast also has two other divisions – urology and the wound and skin care division. Urology is the smallest division, representing just over ten percent of revenue, and it became a part of Coloplast when Mentor was acquired in 2006. The division has been growing at impressive rates under the management of Steffen Hovard, and for the last two years it has succeeded in growing revenues by around ten percent – and as a result, operating margins have also increased significantly.

 Great potential for increased margins

Almost 14 out of 100 kroner in revenue come from the wound and skin care division. There is significant growth potential in the United States and China, and these opportunities are, among other things, pursued via increased investments in the sales organisation – previously, these investments were lower than they could have been. The profitability of the wound and skin care business has the potential to be significantly improved via economies of scale. Production costs are low compared to sales prices, and operating margins, therefore, depends on how much product volume that can be shipped to the customers. Therefore, there should be significant value in increased sales, and we have great confidence in the prospect of this getting done on Nicolai Buhl Andersen’s watch.

For many years, the management have used the concept of ‘Economic Profit’ in its evaluation of the current business and the potential initiatives to develop it further. We, therefore, remain highly confident that management will be disciplined when it comes to allocating investments between the four divisions and investing in the areas with the most potential for value creation.

Freedom of choice is a positive for Coloplast

Coloplast has almost 40 percent of the global market share within ostomy products, but this is very much a result of the dominant share it holds in Europe. In the United States, by comparison, the market share is around 15 percent
– though it is rapidly growing, with the company aiming to get to 20 percent. As previously mentioned, Coloplast is not on contracts with the major purchasing organisations and has therefore taken other steps to secure a place in the market.

The ‘Coloplast Care’ customer programme is part of this effort. Care was launched in 2011, and approximately every third ostomy patient is registered in the programme – thus, there are good reasons for believing that the market share will continue to grow.

One of the ways, by which this customer programme can impact Coloplast’s ability to gain market share, is through free choice. Coloplast generally finds that distributors tend to prefer selling products where they have the lowest costs, as sales prices are fixed on the basis of public reimbursement schemes. However, patients are free to choose, and can thus ask the distributors for products that may not be on the first list they receive. For Coloplast, this can be an opportunity for growth – they can let patients know that they have the freedom to choose and at the same time, of course, tell them about Coloplast’s own products. Due to the proportion of the healthcare costs that patients have to pay for themselves, patients generally tend to spend less time in hospitals in the United States compared to Europe, and as a result, product loyalty is more often built after they have left the hospital.

The sales processes are very different in the company’s various markets. The American market for ostomy and continence products is very much about the distribution network, while on the European markets, it is more often about becoming the product of choice for hospital nurses due to the longer hospital stays of patients. Sales investments in the skin and wound care part of the business also require close contact to doctors and nurses, as this can act as a point of access to customers. It may sound simple, but it is effective.

 Despite acquisitions, the focus continues to be on organic growth

Sales-related investments such as these were part of the reason for Coloplast changing its financial targets in November 2017 and adding another two percent of revenue to investments in order to better exploit the opportunities seen by the country managers. We have a positive view of these strategic initiatives and we see them as creating a lot of value. It is difficult to increase your growth rates without investing the necessary capital when growth rates are already high.

Currently, the Executive Board consists of three people: Kristen Villumsen is joined by Anders Lonning-Skovgaard as CFO while Allan Rasmussen, who has been with Coloplast for 27 years, takes care of the daily operations. This includes the big task of overseeing the transfer of manufacturing from Denmark to countries such as Hungary, and the starting up of a new factory in Costa Rica. The factory in Costa Rica should be seen as an important part of the strong investment in the American market.

Allan Rasmussen has made a large contribution to Coloplast’s significant increased margins by having a strong focus on optimising manufacturing costs and contribution margin per unit. Anders Lonning-Skovgaard has been CFO at Coloplast since 2014, but he has been with the company for more than 12 years.

Coloplast is financed conservatively, and thus, debt amounts to only 0.2 years of EBITDA. The approach involves only taking on debt if interesting and value-creating acquisitions can be identified, and debt is therefore not used to finance the ongoing dividend payments and share buyback programme. Over the last two years, Coloplast has acquired distributors like the US online distributor Comfort Medical and Lilial, a French company. We have great faith in management’s discipline when it comes to future acquisitions, but we appreciate the fact that the main focus is on growing the existing business.

Since 2015, Coloplast has paid or set aside around 5.3 billion kroner due to lawsuits in the United States concerning the urology side of the business. These lawsuits concern complications with products that were initiated before Coloplast owned the business, and we are happy to note that it is not expected that the costs will exceed the amounts already set aside. Management reports that more than 95 percent of the cases have been concluded and that the process will be completed by the start of 2019.

Coloplast pays an annual dividend of 16 kroner, which is equivalent to a dividend yield of approximately 2.5 percent. On top of this, the company has a share buyback programme amounting to around 500 million kroner, resulting in total shareholder distributions of around three percent of the market value.

The opportunities that the Board of Directors and the Executive Board have for making, and implementing, long-term strategies are supported by the Louis-Hansen family, who owns 70 percent of the voting rights in Coloplast (mainly through unlisted Class A shares). The family founded Coloplast in 1954 after Elise Sørensen, a nurse, came up with the idea of an ostomy bag.

Coloplast continues to sell lots of ostomy bags, and is a global Danish success story. We continue to be satisfied co-owners of Coloplast – a profitable business model and long-term patients are, as we see it, an attractive long-term investment.