The following analysis is a valuation of Edwards Lifesciences (EW), a healthcare equipment company that according to S&P's Global Industry Classification Standard is using an economic profit model, a primer on which can be found here. To begin, the company’s operating segments are detailed while also analyzing recent operating performance. Next, the company’s adjusted financial accounts and market capitalization are presented, leading to a base valuation scenario. A number of alternate scenarios are considered given variations in assumptions. After integrating a forward looking view of the company’s position, an investment conclusion is formed.
The following table shows the four business segments Edwards operates in as well as their sizes and growth since 2008:
The largest and highest growth segment is the heart valve therapy business. Growth has been mainly driven by new transcatheter heart valve products although older technology pericardial tissue valves grew strongly over the historical period as well. The company continues to roll out its newest line of transcatheter products around the world with approval in the U.S. expected this year, leading to large projected revenue growth over the next two years. While the new product is leading to strong sales because it allows higher-risk, previously inoperable patients to now receive surgery, the market opportunity for the existing technology heart valves has been moderating in recent quarters due to slow procedure growth. The company sees 3-5% underlying sales growth in the heart valve business excluding the transcatheter market.
The transcatheter heart valve line currently has one significant competitor in the form of Medtronic’s (MDT) CoreValve. However, it was found to infringe on Edwards’ patents (see Reuters story) and a jury awarded Edwards $74 million. Although legal appeals continue, Edwards claims that it will be able to recover "additional damages due to CoreValve's continued infringing sales" (2Q11 10-Q Note 11) from Medtronic based on its interpretation of the district court ruling if that firm continues to sell the product.
The critical care segment is Edwards’ second largest business and has also shown strong growth over the past several years. Revenue in the above figure has been adjusted for the divestment of the company’s hemofiltration products in 2009. The key products in this segment are hemodynamic monitoring systems and associated pressure transducers. Growth has been driven by the company’s latest technology in the area, the minimally invasive line of products known as Flotrac. As far as the pipeline is concerned, Edwards is developing an automated glucose sensor for the hospital segment which begins selling in 2012. The product is being developed with DexCom (DXCM). The company sees underlying sales growth of 5-8% in this segment.
Cardiac surgery systems are a relatively small part of Edwards’ business but have grown nicely over the past several years. The segment comprises a large number of disposable products that are used in the process of performing cardiac surgery as well as a relatively smaller portion of systems used to perform ablation procedures. The company sees underlying sales growth of 6-8% in this segment.
Vascular, the company’s smallest segment, consists primarily of balloon-catheter products and surgical clips and clamps. Revenue in the segment has been adjusted to reflect the divestment of the LifeStent product which occurred in two stages over the past several years. The remaining business is mature and is not growing.
For the company’s R&D budget as a whole, about 75% of its spending is in the heart valve therapy segment and about 10-15% is in the critical care segment. The majority of heart valve spending relates to the newest transcatheter products. In analyzing where future growth will come, focusing on where the R&D money is being spent should yield the greatest results. Investors should look for product announcements and sales growth in heart valves to see if the increased investment is paying off over the next several years.
The table below shows the current market capitalization of the company, with the equity trading at $74.63:
Edwards is majority capitalized by equity while employee stock options constitute the second largest claim on the value of the company. The average strike on the existing 11.2 million shares of stock options is $27.62, giving the options a delta of 1, meaning that any improvement in the company’s fortunes will have to be shared equally with option holders. The company’s cash position more than offsets its debt and the negative legal liability represents the expected payment to the company related to litigation with Medtronic.
Adjusted Financial Accounts
The following table shows gross income assumptions for the base valuation scenario:
The base period for the valuation is the 12 months starting 4Q11 through 3Q12. Edwards is expecting a large jump in profitability due to the introduction of new products which is the reason for using a forward valuation. Given the forward nature of the valuation, the extra value associated with the new business has been discounted at the cost of capital.
Net income of $287 million represents about $2.50 of EPS per basic share or about $2.42 per diluted share. For reference, FY12 First Call earnings are at $2.78 per diluted share. However, those estimates do not include the negative impact of the new medical device excess tax (0.09 cents/share) and they also include investment income (0.03 cents/share) which are deducted since cash is added back to firm value in the model. After all the puts and takes, the estimated net income in the model generally conforms to one year forward analyst estimates.
Turning to invested capital, as the table below shows, the company’s largest portion of invested capital is in R&D and fixed assets:
All accounts have been adjusted forward one year in order to match the base period for earnings which is also one year forward. Therefore, this is an estimated one year forward look at invested capital.
As with most technology oriented firms, Edwards’ major asset is the research and development that goes into its products. The capitalization period for R&D is six years and adjustments have been made to reflect greater future asset intensity in R&D and rising costs.
The capitalization of advertising reflects an estimate of advertising spend based on Schonfeld & Associates data for the medical device industry of 0.6% of sales. Marketing reflects a small, arbitrary portion of estimated direct salespersons' salaries and expenses. The purpose of this last adjustment is not so much to impact valuation, but to get a slightly more accurate picture of returns on capital in order to analyze the company’s ability to sustain its current level.
Valuation and Scenario Analysis
The following table details the internal rate of return (IRR) calculation used to determine the company’s returns on capital:
The company’s IRR is 18.3% with a reinvestment rate of 12.8% which assumes about 57% the company’s gross cash flow can be reinvested at the IRR. The balance is assumed to be invested at the cost of capital, leading to a modified IRR (MIRR) of 15.6%.
Given a real (inflation-adjusted) cost of capital of 5.6%, the company currently earns close to three times its cost of capital. Sustaining this level of returns is only possible through continued innovation, although barriers to entry in this industry should provide some protection from returns falling too far. At the same time, competition and a concentrated pool of buyers for the company’s products are risks to sustaining this level of returns.
The following table summarizes Edwards’ valuation:
The valuation is broken into two parts, “existing business” which is the value of the existing amount of gross income given constant invested capital and the value of growth, both in invested capital and gross income simultaneously and at the same rate.
The value of the existing business (projected one year forward) is $38.20 per share. Turning to growth, at a 7% rate of gross income and asset growth, which implies stable returns on capital on new business, the value of that growth if maintained for eight years is $19.20 per share. In reality, the 7% figure will serve as an average over that period due to the inherent volatility in growth and the likelihood of growth trailing off at the end of the period. For reference, the company is expected to grow invested capital as defined in the model at an 11% rate over the next year. At the bottom of the table, sensitivities around the growth rate and longevity are given. These sensitivities are accurate around the baseline but at multiples of 3-4x, for example adding 3-4% growth, they start to lag the real impact due to compounding.
Taking the existing and growth values together, we get an equity valuation of $57.40. The market is pricing the stock at about $74.60 which implies a valuation gap of $17.20. How could the market arrive at this valuation level? Since Edwards’ story is really about growth, it is likely that the market is forecasting stronger growth than modeled. One scenario which could set the value equal to the market would be gross income and asset growth of about 10% a year for nine years. This would more than double the level of gross income the company generates.
The table below outlines the impact of two alternative valuation scenarios which are not part of the valuation:
The first scenario is straightforward, as part of H.R. 4872 (111th): Healthcare and Education Reconciliation Act of 2010, a medical device excise tax of 2.3% was instituted on sales of such products within the U.S. While a low probability the event, a repeal of the excise tax would generate about $1.50 of additional value for Edwards’ stock relative to the base valuation case.
The second valuation scenario some investors may want to consider is the possibility that Edwards has some future product liability (including patent infringement) issue. There is no getting away from product liability in medical devices and if there is a problem it can be a large financial burden, not to mention having an impact on future sales. The $2.50 negative impact highlighted comes from the direct impact of a 20% chance of having a $1.5 billion ($300 million expected value) event sometime over the company’s asset life. To be clear, there is zero indication that Edwards has any product liability issues currently and this large number represents in my view a worst case scenario, but for cautious investors it should give some guide to the magnitude of the issue.
One valuation factor not covered above for this company is its acquisition value since it is small enough and has a good enough growth story to fit into the portfolio of several larger companies. Johnson & Johnson (JNJ) has been mentioned as a potential acquirer recently in a Reuters article and the company would fit into the product portfolio of Abbot Laboratories (ABT) and Medtronic (MDT) as well, in my view.
The question is what type of a value an acquirer could pay for the move to make financial sense. Typically acquisitions are done at least 20% above recent average market value and often much higher. Those premiums are paid for by synergies, typically in the case of growth companies, those are revenue synergies because it is difficult to take much cost out of the majority of growth businesses. On the other hand, a larger company may be able to control future costs better, wringing out a percent or two of IRR over time. Leaving that aside for a moment, in order to justify a premium of 30%, an acquirer would need to grow the business at 14% per year for 10 years.
However, even at a 14% growth rate, it wouldn’t leave with the acquiring company with any excess value which is the purpose in any acquisition; that is, to create value for shareholders by investing at rates higher than the cost of capital. From my own perspective, I would not be willing to hold this stock at the current valuation expecting an acquirer to purchase at a 30% premium (the minimum in my view to get a deal done) based on the growth rates needed to begin justifying that value.
Turning to the standalone value of the company, it is the growth rate and longevity that will make the most difference for this company. I see much promise in the short-term growth potential of the company due to the new heart valve products. However, in order to justify today’s equity valuation, Edwards will need to match its average growth in operating income over the past 10 years of 10% for the next 10 years, which I see as difficult and leaving little margin for error.
Furthermore, looking at historical growth, it has come in waves, for example from 2005-2007 operating income hardly budged after increasing rapidly in the three years preceding. Looking at the company’s somewhat meager product pipeline (beyond SAPIEN and its derivatives), it is very possible that we are seeing another burst which will be followed by a leveling off before growing again if the company can deliver a new hit product.
Keeping these factors and product liability in mind, I would not be comfortable holding the stock above the high-50s and at that, I would need to be very comfortable with the growth story. I believe investors with a greater understanding of the financial impact of pipeline products beyond SAPIEN and its derivatives could get comfortable at a higher valuation. Further, the stock should be supported by acquisition possibilities from larger competitors around that level. If the stock does fall to the mid-50s, it is likely that investors have started to doubt future growth based on weak results - this highlights the need for a potential buyer to continue to believe in the company’s growth story even in the face of slowing current grow.
On a final note, I believe the most important function of management in a large company is to effectively deploy capital resources. The sales of smaller product lines and the reinvestment in new products shows to me an effective management team that is willing to make changes to drive the most effective growth and maintain high returns on capital. For that reason I give the management high marks.