Although I have been writing for some time that Edwards Lifesciences (NYSE:EW) is significantly overvalued by the market, I don’t take any particular pleasure in seeing the stock down almost ¼ over the past year and year-to-date in 2013. Even so, it’s a valuable reminder as to the risks of getting a little too bullish about first-movers in fast-growing markets and the danger of the idea that "valuation doesn’t matter."
While the valuation has indeed come down significantly for Edwards, so too have the growth expectations. I do believe the market for transcatheter heart valves will exceed $4 billion in 2020 and that Edwards will remain the market leader. With free cash flow likely to grow at a low-teens rate and the stock slightly below fair value, these shares look interesting for more risk-tolerant investors.
Where have all the flowery expectations gone?
Over the last few quarters, investors have had to accept and adapt to the reality that the transcathether aortic valve implant market is not quite the "build it and they will come" market that analysts and investors had been projecting. In fact, U.S. growth/revenue for Edwards has been below expectation for 3 straight quarters, and the OUS (Europe, at this point) market has seen growth dip into the high single digits due to both market factors (a tighter spending environment) and competition from Medtronic (NYSE:MDT).
With that, near-term expectations for earnings have fallen by almost 10% for both 2013 and 2014. What’s more, these shortfalls have analysts questioning their original assumptions about U.S. market potential. Last and by no means least, various surveys and conferences have suggested that both St. Jude Medical (NYSE:STJ) and Boston Scientific (NYSE:BSX) may be able to generate more initial interest in their valves than analysts had expected, even given how far behind they are in terms of time to market.
Other businesses not helping
The discussions around Edwards Lifesciences tend to be "all TAVI, all the time", but as of the first quarter at least, TAVI revenue is still just about one-third of the business and roughly the same size as the surgical heart valve business. Unfortunately, these other Edwards businesses aren’t really helping the outlook.
Surgical heart valve revenue was down 3% for the first quarter, with tissue valve revenue down 3% and repair product revenue down 3%. Cardiac surgery revenue was flat, while critical care revenue was down about 4%.
Now, I’m not saying these businesses are underperforming. Based on the performance of other companies in the tissue valve space (like St. Jude and CryoLife Inc. (NYSE:CRY)), Edwards seems to be doing no worse than the market. Likewise, the performance of companies like ICU Medical (NSDQ:ICUI), C.R. Bard (NYSE:BCR), and AngioDynamics (NSDQ:ANGO) doesn’t suggest anything too out of line about Edwards’ critical care or vascular businesses (and the critical care business may still be gaining share).
To a large extent, these businesses are stuck in the short term, as patient volumes and reimbursement pressures are not likely to improve notably. It does raise the question, though, of whether Edwards management has put too great a focus on the TAVI business, at the expense of building other growth drivers for the future. For instance, I don’t believe anybody really expects tissue valves or critical care to be significant growers in the future, with single digit market share maybe supplemented with some share growth.
While Edwards was building the TAVI business, companies like Medtronic, St. Jude, and Boston Scientific were out buying (or investing in) businesses like Ardian, Cameron, CardioMEMS, and so on. Given Edwards’ existing sales force and presence in the critical care and cardiac markets, could they not have taken advantage of some of these same opportunities to get more involved in diagnostics/monitoring, renal denervation, a-fib, and so on?
Growth – and competition – are on the way in TAVI
Turning back to the core driver of the Edwards Lifesciences story, I do believe investors have good reason to expect ongoing growth in the transcatheter valve market. There have certainly been some initial bumps – reimbursement has been inconsistent, patient outcomes correlate with surgeon experience, and the promised overall cost savings have been compromised by longer-than-expected post-procedure hospital stays.
Even so, I expect the addressable market to quadruple from 2013 to 2020 (to nearly $4.5 billion), making it one of the more appealing markets in med-tech right now (and probably similar to the emerging renal denervation market). While I think costs will limit adoption in low-risk patients (to around 10%) and medium-risk patients (to around 20%), I do believe a sizable majority of high-risk and inoperable patients will get transcatheter heart valves.
One of the important questions is how much of that market Edwards will ultimately have to share. Although Edwards has had some success in IP litigation against Medtronic, Medtronic is not going to go away, and Medtronic seldom fails to gain significant share in its addressed markets.
Looking a little further ahead, both St. Jude and Boston Scientific will be entering the market relatively soon. There is a large amount of debate among sell-side analysts about whether these two companies have products that are good enough (and/or different enough) to compensate for the delay in getting to market (during which time Edwards and Medtronic are getting physicians trained and familiar with their products). I happen to believe that the various product features of these valves (better cuff designs, repositionability, etc.) will get them noticed, but I don’t think it will result in more than 30% share between them.
My opinions on long-term market share are at odds with most sell-side analysts. I believe that Edwards will remain the leader through 2020, but will see its share fall below 40%. At the same time, I think Medtronic will get to about one-third market share relatively quickly and then stay put. The bigger deviation is with St. Jude and Boston Scientific – I think these companies badly need these products to succeed and will compete fiercely for share, leading to roughly 25% to 30% share long term. If I’m significantly wrong (many, if not most, analysts seem to think that they will combine for between 15% and 20% share), that remainder would likely go about two-thirds to Edwards and one-third to Medtronic.
The bottom line
While the Street seemed happy to see Edwards lift its share buyback authorization to nearly $900 million (with an incremental $750 million authorization), I would have much rather seen this capital go towards growth-oriented M&A. Just as Boston Scientific and St. Jude have seen renewed investor enthusiasm (and bigger valuation multiples) as acquired products come close to primetime, so too do I think Edwards would serve its shareholders better in the long run if it added new products/technologies with growth potential.
As it stands today, I’m looking for Edwards Lifesciences to post compound annual revenue growth of about 6% to 7% over the next decade. I expect TAVI revenue to grow at a low teens rate (against a 17%-18% market growth rate) due mostly to competitive share loss, while I look for the legacy Edwards businesses to be consistent low single-digit growers. I do expect ongoing margin and cash flow improvements as TAVI becomes a bigger part of the business, such that free cash flow could grow at a mid-to-high teens rate.
Work that back, and a fair value of nearly $70 seems reasonable. While that’s not a big discount to the current price in the mid-$60s, I would remind investors that the above average free cash flow growth should lead to above-average year-to-year appreciation potential relative to the market. With so many other med-tech stocks so strong recently, Edwards looks like a decent opportunity. I’d be wary of another disappointment, but given the old wives tale that med-tech companies disappoint in 3s, maybe Edwards is ready to restore some of the faith and confidence it has lost from the Street.
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 email@example.com.