It is not easy to turn around a struggling medical technology business. It took a while for Covidien (COV) to really get back into the swing of things, and Johnson & Johnson (JNJ) still has a way to go, but those companies pale in comparison to the challenges at Boston Scientific (BSX). While this quarter was not a disaster, and the company does have some valid opportunities in its pipeline, it just feels like the newsflow from this company has been unrelentingly disappointing for quite a while now.
Worrisome Share Losses In Q2
Boston Scientific reported a sales miss, as revenue fell 7% as reported and about 4% net of foreign currency. Unfortunately, the company's two most significant businesses led the declines - revenue in cardiac rhythm management (CRM) fell almost 10%, while drug-eluting stent sales fell about 20%.
Gross margin was surprisingly strong, rising two points sequentially and three points year on year, but given the weakness in key businesses, I wouldn't bank on this improvement being sustainable. Even with the improved gross margin, operating income fell 12% and operating margin worsened by about 70 basis points.
Sub-Q To The Rescue?
Boston Scientific's CRM business is simply a mess, as the company continues to loss ICD share to Medtronic (MDT) and St. Jude Medical (STJ), even during a time where worries about St. Jude's leads should have been a small help.
Maybe there's still hope. The company saw a favorable panel meeting for its S-ICD, a subcutaneous ICD system that could address about one-third of the market with a much less invasive approach. Although I believe in the basic promise of sub-q ICDs, I wonder if Boston Scientific still has the leverage to really make this into a winner - the company will have to battle and win back accounts from Medtronic and St. Jude, or this will simply be a like-for-like cannibalization/substitution for its ICD business.
Days Late And Dollars Short
The worst indictment I have to offer against Boston Scientific is that it has become a lagging, reactive company. Yes, Boston Scientific does have a transcatheter heart valve in the works to compete with Edwards Lifesciences (EW), Medtronic, and St. Jude, but it's a couple of years behind. Likewise in the emerging fields of renal denervation, neuromodulation, stents, and atrial fibrillation.
Though there is room for a #3 in what would could well be multiple billion-dollar-plus markets, Boston Scientific is going to have an uphill battle to secure meaningful share and that could force higher marketing spending. What's more, while Boston Scientific's products are not bad (their heart valve is repositionable, whereas Edwards/Medtronic is not), the long lead time allows the leaders to re-engineer better features into their successive products.
What's more, a lot of Boston Scientific's best growth opportunities have come from outside the company. The S-ICD? Bought in with Cameron Health. Transcatheter heart valve? Bought in with Sadra. The Alair bronchial thermoplasty product? Bought in with Asthmatx. There's nothing wrong with buying growth - Medtronic, St. Jude, Covidien, and J&J have all done it - but there is a limit to how far you can get that way, and it does raise questions about the company's internal R&D capabilities.
Can Alair Breathe In New Life?
I'm cautiously optimistic about the potential for Alair as a surgical intervention in cases of severe asthma. The patients and doctors I've communicated with were quite positive on it, and the numbers add up quickly when you consider over 2 million potential patients and a $7,500 ASP. Right now there is insufficient reimbursement for the procedure, but I would certainly hope that fixing this is a top priority for the company.
The Bottom Line
Potential isn't, and has never been, the problem at Boston Scientific. It's actually easy, in fact, to calculate a fair value in the high single digits to perhaps even the low teens. The problem, though, is whether management can execute on this opportunity - can they keep the pipeline moving forward, build up products like S-ICD and Alair, and stem the bleeding in the essential CRM and stent units?
I don't see how any investor can answer that question with an unequivocal "yes". Accordingly, while I do believe Boston Scientific has a chance to grow free cash flow by more than 10% (compounded) over the next decade, I don't think I have quite the faith in this company that it would take to make a big commitment with my own funds.