By Debbie S. Wang
Boston Scientific (BSX) appears to be in a fast-follower position, now that it has fallen behind competitors in developing pipeline technologies, and we believe its formerly wide economic moat has narrowed. We think Boston's new role as the potential third or ancillary market entrant for technologies such as transcatheter heart valves, MRI-safe cardiac rhythm management products, and neuromodulation gives it a weaker competitive position. While we expect the firm can exist comfortably as a fast follower, this is qualitatively different from its previous role as a pioneer. We think this will translate into less power to command premiums for new technology.
Our moat ratings for the remaining cardiac device companies-- Medtronic (MDT), St. Jude (STJ), and Edwards Lifesciences (EW)--are unchanged, as the field is already highly consolidated, which should result in less supplier switching. Most cardiac markets, including pacemakers, implantable cardioverter defibrillators, and heart valves, are divvied up among just three major players. Considering that product recalls are a hazard for any cardiac device maker, providers are reluctant to put all of their eggs in one basket with a single supplier. We think this will leave the door open for all three firms.
Boston Scientific's Trailing Position Has Implications for the Future
Innovation is the life blood of this industry, so Boston's laggard position behind Medtronic, St. Jude Medical, and Edwards Lifesciences has implications going forward. Boston has been plagued by operational issues in the wake of its 2006 purchase of Guidant and struggled with the debt load brought on after that acquisition. In the past, the firm (and Guidant's cardiac rhythm management business) consistently had been one of the first to introduce new features and innovative technologies. However, in the past couple of years, Boston has begun lagging behind, especially on the development of pipeline technologies that we expect will drive growth during the next three to ten years. At this point, we anticipate Boston will trail its rivals by two to three years when it comes to MRI-safe CRM devices, transcatheter heart valves, ablation for atrial fibrillation, and neuromodulation.
This industry is highly consolidated and dominated by just a few large companies, so being the third to market isn't necessarily the end of the world. St. Jude had historically held that fast-follower position behind Medtronic and Guidant in the CRM market, but still enjoyed a narrow moat and consistent economic profits. The high barriers to entry--which include a substantial base of intellectual property, innovative engineering, and an extensive network of relationships with practitioners--are difficult for startups to create from scratch. Moreover, by the time a small startup actually commercializes its product, one of the large device makers is likely to swoop in and purchase the smaller fish. Thus, it is not surprising that the cardiac rhythm management market has been a stable oligopoly for at least the past decade.
Boston's new status as a fast follower is somewhat different from its past position as a pioneer. We anticipate the firm will not be able to garner premiums on new products that are quite as attractive as in the past, when it was the first or second to market. Conversely, we also do not expect to see any new entrants gain significant strength to displace Boston from its third-place position.
We remain wary that outgoing CEO Ray Elliott was able to completely ferret out all of the firm's operational issues. Considering Boston's recent record, we would not be surprised to see another glitch come up under new president (and expected future CEO) Michael Mahoney. We had a great deal of confidence in Elliott to put things right, based on his record at Zimmer and his many years in the medical device industry. So if he couldn't fully turn things around at Boston, we're not particularly confident that Mahoney will be able to do much better.
Finally, we note that Boston's return on invested capital suffered greatly following the high price it paid for Guidant. Now that the implantable cardioverter defibrillator market is mired in low-single-digit growth, thanks to larger clinical issues that are unlikely to be resolved soon, the expected return on the Guidant investment will leave ROICs depressed for the foreseeable future. This clearly sets Boston apart from its peer group, which generally earns attractive ROICs in excess of weighted average cost of capital.
We are leaving Medtronic's and St. Jude's wide moats and Edwards' narrow moat unchanged. These companies continue to pioneer emerging technologies, even as the clinical bar has been raised. Moreover, providers are reluctant to limit themselves to a single device maker, because product recalls are a fact of life for any device manufacturer. However, we are increasing the margin of safety required for Medtronic and St. Jude (by raising our uncertainty rating to medium from low), as the prospect of Medicare reimbursement cuts looms over the entire industry.
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