Edwards Lifesciences (EW) has done a lot of good things - foremost among them being the decision to move beyond its stable, unexciting legacy businesses into more dynamic and more profitable markets. It's a model that St. Jude Medical (STJ) has used to good effect, and it has certainly made this a much more interesting company over the past three years.
The problem, though, is whether or not investors have gotten a little too excited about Edwards Lifesciences and its transcatheter heart valve products. While transcatheter aortic valve implantation (TAVI) is a legitimate breakthrough in medical technology and likely to be a multi-billion dollar market, investors seem to have overshot the mark. Even as Edwards stock has come off about 20% from its highs, current valuation still presupposes a huge level of market transformation.
Sapien Should Be A Winner
It's hard to argue that Edwards' Sapien platform is not a game-changer in cardiac care. Not only does this transcatheter approach (the replacement valve is delivered through a catheter and a small incision in the leg or a minithoracotomy) open up treatment options for patients with aortic stenosis (a serious condition) who are not eligible for surgery, but it can also offer certain advantages to patients otherwise eligible for surgery.
About one-third of severe aortic stenosis patients are considered inoperable, and another 15% or so are considered high-risk for surgery. If Edwards and eventual competitors like Medtronic (MDT) can garner ASP's in the $20K's for these valves worldwide, just those categories could be worth nearly $4.5 billion a year in sales (at 100% penetration) - not bad for a company about $1.7 billion in trailing revenue.
Waiting For The FDA, And The Panel Meeting Could Be Rigorous
Although Edwards has FDA approval for the use of Sapien in inoperable aortic stenosis patients, the company is still waiting for approval in high-risk surgery-eligible patients. One of the recent issues for this stock has been the ongoing delays in getting an FDA panel meeting on the schedule. Although originally investors expected a meeting in the spring, the company has announced that they're finally on the calendar in June.
In the very near term, this is going to crimp the company's revenue expectations for 2012, and sell-side analysts have already started moving their numbers down. Even with that risk more or less known, there is a risk that the panel will be more contentious than people expect.
Since these surgery-eligible patients do have other options, I expect that there will be a rigorous discussion of the safety and risk-benefit of the approach. On the plus side, the most recent long-term clinical data has shown a slight edge in all-cause mortality for Sapien versus surgery at two-year follow-up (33.9% versus 35.0%). That's not a statistically significant difference, but it's positive in the sense that the transcatheter approach doesn't increase the mortality risk.
What is more problematic, though, is the stroke risk. In the Sapien group, 7.7% experienced strokes, while 4.9% of surgery patients experienced strokes. This will focus even more attention on something called paravalvular regurgitation - basically leaks around the transcatheter valve. About 50% of patients show some leakage, with about 10% showing severe leakage. Unfortunately, almost any leakage seems to be tied to a higher stroke risk.
Now, Edwards does have ways of addressing this. There are cuffs (available in Europe) and embolic protection devices that help, as do a wider range of sizes and different delivery options, but that doesn't mean that the June panel meeting won't feature a rigorous discussion of this risk. It's also worth noting, more from a market acceptance perspective, that the incidence of leakage does seem related to physician experience.
Competition Is Coming, But Edwards Can Hold The Edge
Medtronic is furthest along amongst Edwards' would-be US competitors, as its CoreValve is well into trials and is also approved and marketed in Europe. While CoreValve is likely to be about a year or two behind Sapien in the U.S., investors should also remember that Edwards is further along with follow-on products like the Sapien XT (which could launch alongside CoreValve in the U.S.) and additional delivery options.
While the basic performance of the valves seems roughly similar, a lot of competition will come down to sales detailing, the number of sizes and delivery options available, and the relative performance of the valves in various approaches (transformal, transapical, and so on).
St. Jude Medical is behind Medtronic's U.S. timeline with its Portico valve, while Boston Scientific (BSX) is a little further behind with its Sadra. At this point, I would not expect a lot from Boston Scientific unless it can show a true distinct advantage in clinical trials (as the company has no existing heart valve business to leverage). St. Jude may be the more underestimated player at this point, as the company at least has an existing valve business to leverage.
What's This Worth?
I do believe that there's a good chance that Edwards will hold better than 40% share even once everybody is on the market, and I wouldn't completely rule out a 50% share (as Edwards and Medtronic have largely split the European market). So what's that going to be worth?
Across all categories, I believe there are over 400,000 patients a year potentially eligible for serious intervention, which suggests an addressable US/European market above $9 billion (at 100% penetration). This breaks down to about $3 billion in inoperables, nearly $1.5 billion in high-risk, and close to $2.5 billion in medium-risk and low-risk each. What's more, these numbers should grow with aging populations in North America and Europe.
But how much of this is accessible? I have no trouble believing that penetration in inoperables will hit 50% quickly and surpass 75% within ten years. The high-risk population could likewise support better than 50% penetration, particularly if physician experience and follow-on products improve the leakage issue. The moderate-risk and low-risk patients are the big unknown - low-risk penetration will probably stay low, but moderate-risk could surprise, particularly if the economics prove to be good.
Although I've seen some analysts suggest that TAVI could capture 90% of its total market, I'm skeptical. Stents have never captured that much of their addressable market, nor have drug-eluting stents captured that share of the stent market. What's more, adoption has been slow in Europe so far (below 25%), even though the devices have been available for several years. Certainly the poor economic situation in Europe hasn't helped reimbursement, but investors should remember that doctors are not necessarily as aggressive as optimists like to believe.
One of the remaining issues to resolve in the United States (assuming the June panel is tough, but not negative) concerns reimbursement. At this point, I believe Edwards and Medtronic are going to shoot for ASPs of close to $30,000 in the U.S., but that will probably decline a bit with time.
The economics on TAVI look interesting. There are still a lot of unknowns about reimbursement, but looking at Edwards' experience to date, it looks like the surgical procedure itself is much cheaper (by about $20,000), but the post-procedure costs are much higher for surgery (by $20,000 to $27,000) due in part to the longer post-surgical hospital stay. Consequently, there's an argument here that TAVI procedures save money. They also seem to be more profitable for hospitals (by at least a few thousand dollars), but I want to emphasize that this is all a rough analysis at this point.
What About The Rest Of The Business?
Edwards is not just all about Sapien, though that is clearly the dominant driver of its future earnings. The company is still a market leader in tissue valves, where it competes with companies like Medtronic, St. Jude, and Cryolife (CRY).
The company also has a sizable critical care business - a business where Edwards has long enjoyed market leadership and healthy margins. There's a risk here, though, that ICU Medical (ICUI) is going to shake things up a bit. With the acquisition of Hospira's (HSP) critical care business, ICU Medical is likely to be much more invested in this market and much more interested in product development and renewed marketing efforts.
Edwards' other businesses, including cardiac surgery, vascular, and a relationship with DexCom (DXCM) for continuous glucose monitoring in hospital settings, are decent businesses, but dwarfed by Sapien and transcatheter valves.
Putting It Together
If my base case assumptions (75% penetration in inoperable, 50% in high-risk, 10% in moderate-risk, and 5% in low-risk in 2017) hold up and Edwards commands 42.5% share in 2017, that's $1.5 billion in high-margin TAVI revenue. Distilling that through a DCF model, fair value for Edwards falls in around $70 per share - not a terribly compelling price relative to today's price.
That all assumes roughly 36% TAVI penetration in five years and that seems respectably ambitious. Say that rises instead to 50% (quite ambitious for five years), but Edwards keeps basically the same share, and the incremental sales contribution jumps to about $2.1 billion and the fair value rises into the low $80s.
Consequently, I feel as though current market expectations already assume not only sizable market share, but also pretty robust adoption across the market. I think there's a middle ground here - I think the optimists may be right about the eventual rate of adoption of TAVI, but I suspect it will take many years. Consequently, today's fair value frankly isn't all that exciting to me.