It feels like Boston Scientific (NYSE:BSX) has spent the majority of the past decade in a perpetual limbo of ineffectual turnaround. The shares are down ⅔ over that period, while rivals and peers like Medtronic (NYSE:MDT), St. Jude Medical (NYSE:STJ), and Stryker (NYSE:SYK) have been flat, up 50%, and up 100%, respectively, over the same period. Worse still, Boston Scientific transformed from a market leader to a market laggard and squandered an immeasurable amount of credibility and investor goodwill.
If a foolish consistency is the hobgoblin of little minds, though, it’s unwise for investors to just assume that Boston Scientific is done for – and as a dedicated BSX-hater that’s hard for me to admit. It really is starting to look like the company has cleaned up its margin structure and developed a late-stage pipeline sufficient to bring growth back into the picture. While I do believe there are legitimate questions about what Boston Scientific can achieve internally (as opposed to acquiring others’ good ideas), this stock actually looks pretty interesting in a market all too short of good opportunities.
Earnings aren’t great yet, but they’re getting less bad
Let’s be clear – Boston Scientific isn’t going to be challenging companies like Edwards Lifesciences (NYSE:EW) or HeartWare International (NSDQ:HTWR) for medtech growth leadership anytime soon. (At this point, performance on the level of slow-growing Becton Dickinson & Co. (NYSE:BDX) would be a big deal.)
To that end, revenue fell 6% as reported in the first quarter, and BSX did miss the average Wall Street sell-side guess. Organic revenue was down 4%, which was actual worse than in the 4th quarter. The company’s interventional cardiology business continues to pressure results, with revenue down 14% in constant currency, with stent sales down 18%. Cardiac rhythm management is also growth-challenged (down about 4%), but BSX seems to be losing less ground to St. Jude and Medtronic on that front.
With the top ½ of the company’s business so weak, the improvements in the other businesses were overshadowed. Endoscopy was up 5% (good relative to Stryker’s slightly negative result), while peripheral rose 3% and urology/women’s health was flat. Neuromodulation benefited from some sales force turbulence at St. Jude and rose 6%, while the tiny electrophysiology business was down 5%.
Margins were messy, but pretty good on balance. Gross margin improved about 1 point on an adjusted basis, with manufacturing improvements offsetting negative pricing and mix (letting Promus profit sharing savings drive improvement). Adjusted operating income declined 8%, but that was good for a ½-point beat on margins.
Margin details show more opportunities
In a very positive development, Boston Scientific has started giving more detailed information about its segment margins. Some interesting conclusions seem to spring from the data. While the company’s CRM margins are very low (about 12%), some of that could well be due to investments in the S-ICD platform.
Conversely, I was surprised that the Cardiovascular margins were as high as they were (24%) given the fierce competition in stents from Medtronic and Abbott (NYSE:ABT). Likewise, MedSurg margins were nearly 29% in the first quarter. I think this is significant given the investments underway in transcatheter valves (Cardiovascular), Alair (MedSurg), and deep brain stimulation (MedSurg).
Will the pipeline deliver?
Boston Scientific did a pretty miserable job of managing its internal R&D, and as a result the company had to spend hundreds of millions of dollars to buy its way into markets like sub-Q defibrillation (S-ICD), left atrial appendage intervention, renal denervation, and transcatheter valves. This is a case, though, where investors won’t care where the products came from so long as the launches go well.
I’m cautiously optimistic here. While there has been some skepticism from thought leaders regarding S-ICDs, the company is already supply-constrained and it already looks like the product has made a difference in stemming BSX’s CRM weakness.
Better still, it’s looking like the Watchman LAA closure device is a winner. While BSX had an embarrassing spat with the gatekeepers at the ACC regarding an early release of data (which led to the cancellation of the presentation), the company released data May 9 that more than made up for it. The data showed a hazard ratio of 0.66, a ⅓ decrease versus control, and significant improvements in CV mortality (60%) and stroke, embolisms, and CV death (40%) versus the control.
This should have the company on track for 2014 approval, and well-positioned relative to rivals like St. Jude Medical in this space. The next question will be the size of the real market opportunity. Boston Scientific’s management believes it’s a $500 million opportunity, but the popularity of Johnson & Johnson‘s (NYSE:JNJ) Xarelto will be a challenge, as will labeling and physician training. Experience really makes a difference with the Watchman, as tapenade rates decreased from 6.3% to 3.3% as physicians gained experience. That could hamper (or at least slow) off-label usage, which I believe will be a key factor in the ultimate revenue opportunity here.
Other BSX projects have more mixed prospects. I still believe Alair will be successful, but it’s going to take time for reimbursement to develop and Boston Scientific will have to invest significant resources in marketing. The company’s Synergy stent platform is likewise promising, but I’d be cautious about assuming that any company’s stent platform can gain more than a temporary edge.
I’m incrementally less optimistic about renal denervation and transcatheter valves for Boston Scientific, mostly due to the company’s time to market and apparent lack of differentiation. I think Medtronic and St. Jude will likely outdo Boston Scientific in both of these markets.
Learn from the past and build for the future
I think Boston Scientific has done a good job of repositioning itself to grow again. While 2013 will still be a tough year on a reported basis, I do believe that the headwinds from the stent business will abate and allow the company to get back to organic revenue growth (albeit not a lot of it). What’s more, I think the company could show real margin improvement in 2 or 3 years’ time as the launch of new products brings in revenue to offset the considerable cost investments being made today.
I do have some lingering concerns, though. The company still has a debt-heavy balance sheet as a legacy of overpaying for Guidant. More significantly, BSX really needs these new products to work and that will test its sales and marketing capabilities. Last and not least, the company needs to show it has learned from the past decade and won’t make similar mistakes in failing to build for the future – internal R&D productivity and emerging market positioning will both be important in the years to come.
The bottom line
Even though I’ve been pretty cool on Boston Scientific, I’ve actually seen more value in the shares than most sell-side analysts. To that end, I see a fair value of almost $10 today, on the basis of a long-term revenue growth estimate of almost 4% and a free cash flow growth estimate of almost 7% – above my growth estimates for Medtronic, St. Jude, Stryker, Covidien (NYSE:COV), but consistent with a company playing catch-up.
I actually would consider buying these shares today, although cynics may well think of that has a good contrarian indicator that the company has already come as far as it will. Although Stryker is probably my favorite medtech stock today, I do believe there’s potential in Boston Scientific even near its 52-week high and this company could still outperform from here.
Stephen Simpson CFA is a former sell-side and buy-side analyst who focuses most of his professional attention on financial and investment writing. In addition to a decade of work as an analyst, Mr. Simpson has worked as a wet-bench biomedical researcher and a consultant in the med-tech industry, as well as writing on a freelance basis for over 10 years. He can be reached via email at [email protected].
