It was relatively easy to like St. Jude Medical (STJ) in the low-to-mid $30s, but a sustained rally since late November has taken away a lot of this company's relative discount. Now St. Jude faces many of the same problems as most other large med-tech companies - stressed and slow-growing major markets and potentially abundant competition in emerging higher-growth markets. Although these shares are not especially expensive, investors should temper their expectations at these prices.
Q4 More Or Less As Expected
Since St. Jude gave investors an early look at revenue, there weren't a lot of surprises left for the final announcement.
Revenue declined more than 2% as reported, or about 1% on a constant currency basis - marking the fourth straight quarter of +/- 1% organic revenue performance. Sales in the large cardiac rhythm management (CRM) business were down 5% in constant currency, while cardiology sales were up 1%. Atrial fibrillation products remain a strong contributor to growth (up 11%), while neuromodulation was down a disappointing 6%.
Profit performance was basically in-line at the end, but the components were a little different than most analysts expected. Gross margin declined about 60bp, hurt by mix and price erosion in CRM. SG&A and R&D spending were both lower than expected, though, and St. Jude's operating income growth of 4% was a nice positive surprise (about double the rate expected).
The CRM Debate - It's Not Over Til It's Over, But It's Looking Okay
No doubt the biggest controversy at St. Jude is the fate of the company's ICD business, given an FDA warning letter tied to Durata leads. Bullish analysts believe that the data does not support a recall and that St. Jude will get through this with minimal share loss and only some incremental SG&A expense tied to compliance actions. More bearish analysts, particularly Citi's Matthew Dodds, believe that a recall, injunction, and/or consent decree are all still very much on the table, with significant potential share loss (and revenue) consequences.
For now, it doesn't seem that doctors are too troubled by the matter. ICD revenue fell 3% this quarter, with volume up in the high single-digits and ASPs down about 10%, but it looks as though the company at a minimum held share, and may have gained a little from Boston Scientific (BSX). Given that St. Jude's rivals [in particular, Medtronic (MDT)] have been marketing hard against St. Jude's FDA troubles I'd argue that this performance supports the idea that doctors just aren't that troubled by the data seen so far concerning Durata, or at least are still willing to use the St. Jude cans.
Cardio Still Sluggish
St. Jude's performance in cardio was nothing to write home about this quarter. Structural heart products, which includes the company's heart valve business, was up just 1%. Medtronic and Edwards Lifesciences (EW) continue to grow their catheter-based heart valve businesses while St. Jude is stuck with the more humdrum conditions of the traditional market. That said, 2013 looks to be an important year for the company with its Portico transcathether valve - a product that I believe will surprise to the good.
St. Jude's vascular business (the other part of cardio) was down 2%. While this looks weak against the 42% growth shown by Volcano (VOLC) in the FFR business, there are too many other businesses included in this segment (including the relatively slow-growing vascular closure business) to make for a fair comparison, not to mention the impact of the expiration of a distribution agreement that obscures underlying organic growth.
A-Fib Is Doing Well, And More Could Be In Store
While St. Jude's neuromodulation business has gone from mediocre to disappointing, the a-fib business is running strong with 11% growth this quarter - in line with the 14% growth seen at Johnson & Johnson's (JNJ) Biosense Webster division this quarter. While a-fib has been a good (if somewhat small) business for St. Jude for some time, a new product introduction could accelerate this further.
St. Jude is looking to extend and expand its MediGuide technology and product platform. MediGuide is an imaging technology that uses pre-recorded images to assist with heart procedures like ablation for atrial fibrillation. With MediGuide, users can reduce the use of fluoroscopy by two-thirds or more (which reduces agent and radiation exposure to the patient), while cutting procedure times by 20% or more. While St. Jude has been talking about this as disruptive technology, investors should keep some of their expectations in check - it's a promising concept, but doctors can be stubborn about changing their procedures.
The Bottom Line
Management's guidance for ongoing CRM market declines in 2013 was disappointing, but not terribly surprising. All told, it doesn't look like St. Jude is expecting to see much overall revenue growth in 2013, as growth from Portico and a-fib will be offset by sluggishness in CRM and neuromodulation, and opportunities like renal denervation are still some distance from primetime.
I'm looking for St. Jude to grow revenue at a long-term rate of about 3%. Bullish investors will argue that that number is too low given the aging of the population and the growth of emerging markets, but I would argue that intense price pressure is going to weigh on long-term CRM growth. Markets like renal denervation, a-fib, and transcatheter valves could be source of upside. With that revenue outlook, I also see the company gradually improving its free cash flow conversion such that free cash flow margins go north of 20% in about five year's time - again, potentially a conservative outlook given that the company is already close to 19%.
At 4% to 5% forward free cash flow growth, St. Jude's fair value would be in the mid-$40s, while revenue growth on the order of 5%-6% would support a target in the $50s. That leaves St. Jude as modestly underpriced today, but not necessarily a commanding value for new investors - an increasingly common issue in the larger med-tech space.