Background: Medical device manufacturers such as Edwards Lifesciences (NYSE:EW) have certain advantages over pharmaceutical manufacturers, both traditional small-molecule developers and biotechs. Bringing next-generation device products to market can usually be accomplished by showing that they are improvements over the prior version, with no clinical trials needed. By this technique, eventually a very different product can be brought to market without a clinical trial since, perhaps, the initial trial. Of course, clinicals can be valuable for major products to demonstrate to doctors how good a device really is, but time and cost to market can make this market segment very attractive as a business and therefore attractive to investors.
The customer, usually a surgeon or an internist specializing in invasive procedures, likes to stay with a product line he (she) is used to physically working with. Thus, first-mover advantages are very important, more so than in pharmaceuticals, where all the doctor does is write one brand name or another, whichever appears better. Edwards has an important first-mover advantage in several important product lines and has been pressing its advantage aggressively and successfully.
Edwards, as I will refer to EW in this write up, has a long history of innovation that has given it more than one first-mover advantage.
Its main niche is in the mechanical treatment of seriously malfunctioning heart valves. The company is leading the world to less and less invasive treatments, primarily for aortic and mitral valvular disease (the two valves that are part of the left side, or main pumping side, of the heart).
Formed in 1958, the company brought what became for a time the world's leading mechanical heart valve to market in 1960, the Starr-Edwards valve. Later, the company introduced a "tissue" (non-mechanical) valve, the Carpentier-Edwards valve, which has become an iconic brand. This brand continues to bring advance after advance, and has been extended to the technique of valve repair rather than replacement, which usually avoids the use of blood thinners and has other advantages.
The company also introduced the first successful pulmonary artery catheter to assist in caring for critically ill patients. This Swan-Ganz catheter is as famous a name amongst doctors as the iPhone is amongst today's consumers. This innovation led to an important niche in critical care devices for Edwards.
The mindshare amongst the cardiology community that Edwards maintains brings it one opportunity after another. For example, the head cardiac surgeon at Cleveland Clinic had an out-of-consensus idea about what was really wrong with severe mitral valve prolapse requiring surgery. His solution became the Cosgrove-Edwards ring. It did not become the Cosgrove-Medtronic (NYSE:MDT) ring.
What's the value of this reputation? Perhaps not quite "priceless," but it's big. To me, it's worth several P/E levels.
A personal aside: while I am a cardiologist, I am a non-invasive one, not a surgeon. I have never had a professional relationship with Edwards.
Current products: Edwards again began revolutionizing invasive cardiac treatment with a non-surgical alternative to severe narrowing of the aortic valve, known as severe aortic stenosis (AS). The Sapiens transcatheter heart valve was approved for marketing by the FDA in July 2011 for inoperable patients with severe AS. If readers understand what a coronary stent is, they can get an idea of how the Sapiens valve works by thinking of it as a stent but for a blocked valve rather than a blocked artery, for which angioplasty with stent implantation is frequently the indicated therapy.
This limited indication of use only in inoperable patients was importantly expanded last year to include patients who are operable but at high risk of complications from surgery.
Two more versions of this product are under development in the U.S. One of them, Sapiens XT, has recently been approved in Japan. Sapiens 3 is on its way toward commercialization, as well.
Sapiens addresses a large, growing and underserved market. Most cases of AS are related to progressive, age-related valvular narrowing. Thus an aging population develops proportionally more AS, and the "old old" are poor candidates for surgery. AS is a growth field, especially in mature, prosperous economies where life expectancies have been extending.
The current global competitor for this market is the Medtronic CoreValve. Happily for Edwards, it has prevailed in a patent infringement suit against MDT in Germany. It has achieved an injunction on its sale there and is working to achieve the same in the rest of Europe through an action via the European Patent Office. (The CoreValve is not yet marketed in the U.S.)
Sapiens has already become very important to Edwards. In Q2, Sapiens' sales were $182 MM, up 25% yoy. In contrast, total corporate sales including those from Sapiens were only up 7% yoy to $517 MM.
Edwards' future growth is going to come from Sapiens and new products, both transcatheter products and advanced surgical products, probably minimally-invasive ones. To the extent that Edwards is viewed as a one product company, its P/E will be under pressure.
There are perhaps a dozen competing devices in development that may compete with Sapiens. I expect Edwards to maintain a dominant global market share of this growing market.
Other products and pipeline: Edwards intends to grow rapidly to utilize technological and design advances to meet more and more needs of an aging global population. The market is enlarged beyond degenerating heart valve problems, in that in emerging countries, people still suffer greatly from the old disease of rheumatic valvular heart disease. Edwards' latest online presentation concisely lays out what I view as a strong case that there is no practical limit to the company's growth. I do not want to make this article overly-long by delving into the various new products that look to be coming. I'll just say that I'm impressed, both as a physician and as an investor.
Edwards is at risk of margin compression if payors get tough. Most analysts do not expect that to occur in a meaningful way. For the most part surgeons and cardiologists are going to drive product selection, not consumers who can be sold a smartphone because it is cheaper than the innovator's. The doctors are going to choose what they perceive as the best product, and cost of the product will be no object if it is available at their hospital. This point means that, in my view, EW deserves a higher P/E than even the best consumer electronics company the world has known.
EW: The stock: It's hard to beat this chart, which begins in Y2K, the year that EW went public (Yahoo! Finance, semi-log scale):
Along with steady price appreciation, the earnings stream shows growth every year. EW has returned 17% per year for the past 13 years. For people worried about another 1987 or 2008, it may be worth noting that EW rose over 20% in 2008, so it need not drop at all if the average stock plunges; it might even rise.
Here's why I think that EW is on target for a similar performance the next few years.
Quite simply, I think that the best is yet to come. From a stock standpoint, at Monday's closing price of $71.72, the stock has gone nowhere since 2010, having gone vertical since late 2008 into 2010. While there were quarters that missed expectations, EPS growth has been dynamic. This has been fueled both by sales growth and margin expansion. Sales per share have risen 10% per year the past 5 years. Net profit margin rose from 11% in 2004 to 13.5% in 2009 to an estimated 17% this year. I expect further gains in NPM as economies of scale kick in.
The company is strong financially. It ended 2003 with $172 MM in net working capital and $267 MM in long-term debt. This year, it will have about $1 B in net working capital at year-end against about $230 MM in long-term debt. No dividends have been paid, but shares outstanding have been periodically reduced. Shares outstanding reached 120 MM in 2002 and may be at 110 MM at year-end 2013.
The company has guided EPS to $3.00-3.10 for this year. This is against $2.02 in 2011. As usual, the prior year, 2011, also set an EPS record. Current Street consensus is for $3.66 next year.
What is the "proper" P/E for EW? For what it's worth, Value Line's "value line" for EW is 22X cash flow. That would suggest that current fair value is in the low $80's. If consensus is correct for 2014, then fair value next year at the same 22X cash flow would be well into the $90s.
EW has a market cap around $8 B. A premium to that still means that EW would be cheap to a large acquirer. One thinks of J&J (NYSE:JNJ) or Abbott (NYSE:ABT). One might even wonder about Warren Buffett, who loves to leave successful companies alone and acquires those companies with an eye toward the long-term. I would think that 30X current year's earnings would be an attractive price to a financially strong acquirer, and that the deal would likely be even pricier than that. After all, think of the cost of debt and the high likelihood that 30X -- a 3.3% earnings yield, will grow rapidly. Since management only owns a few percent of shares outstanding, takeover talk could buoy the stock if it weakens further, I would think. There is no franchise in cardiovascular devices like Edwards, in my opinion.
Technical position: I want to briefly point out how the above long-term chart shows a steady uptrend which accelerated after the Great Recession ended and produced this 5-year chart:
In the setting of rapidly rising earnings, this chart appears promising. A bit of an overenthusiastic blow-off top formed in late 2010 into 2011. A modest correction occurred, tied into the summer storm that the market underwent in 2011. Then a higher optimistic high occurred last year- a bullish sign in my view. A higher low has now formed slightly above the 2011 second-half low. With reasonably clear skies ahead, I think that there is limited resistance to the stock gradually (or rapidly) sliding on up into the prior trading range in the $90's.
Of course, we all look at charts differently. Personally, I go for fundamentals over technicals, but if I like the fundamentals, I like to also be able to convince myself that I'm not fighting Mr. Market if I go long a stock.
Risks: As a public equity, all that an investor needs to know has been disclosed about EW. For every buyer, enthusiastic or not, there is a seller who may be better informed than the buyer. There may be a breakthrough or two out there that will harm Edwards' operations. Manufacturing could become troublesome. Reimbursements could drop from current high levels. General market P/Es could shrink materially. EW pays no dividend, may never pay a dividend, and thus represents a trading price to investors rather than a source of current income. Risks are plentiful.
Other points: There is no necessity here to review the many other aspects of Edwards' operations. There are many products beyond cardiac valve devices, and a possible investor will likely want to at least explore the company's website to be aware of them. There is a patent dispute ("Andersen patent") in the U.S. with Medtronic. Edwards has received an FDA warning letter. Edwards is planning a trial of a transcatheter valve procedure with micro-anchors, which may bring new capabilities to treating aortic valve leaks without open heart surgery. This could be an important breakthrough. You may wish to begin a thorough review of EW by reading Seeking Alpha's Q2 transcript.
However, the focus of stock traders right now is on valves.
Summary: Edwards is a little-known gem. It is a core part of a modern economy. For my money, what it does is much more important than watching video on smartphones. (There is a decent chance that you know someone who is walking around with an Edwards product in him or her.) Of course, payors know that, which is why it enjoys gross margins around 75%.
Edwards has only $2 B in annual sales expected for 2013, stellar finances, and is the clear leader in a niche (cardiac valve therapy) with almost unlimited global growth potential. EW appears to me to therefore be relatively cheap in a richly-valued market, trading at a price that it first hit nearly three years ago. My guess is that absent major market resets to lower P/E levels aside, EW is ready to move on up in price.
Edwards thrives on innovation, quality manufacturing, and great design. It brings great things to life that people really, really want, and does so in a highly-profitable manner. If this reminds you of a certain electronics company named after a fruit, that's intentional. However, the FDA and other regulatory agencies globally prevent EW from suffering unrestricted competition. Also, of course, being pro-health care is a proven vote-getter for all politicians of all major parties, so EW as a company that brings good things to life benefits from subsidies from taxpayers.
Why not try to get some of your tax money that is helping to subsidize this company back by taking a chance on EW stock?
Under $75 per share (or perhaps a higher price than that), EW is my favorite stock in the medical field, and I would have to think hard to find one with a better risk-reward balance amongst all the stocks I follow.