There's a gray area between not overreacting to one or two quarters of underwhelming performance and willingly ignoring emerging bad news about a company. That seems particularly relevant now with St. Jude Medical (NYSE:STJ), as the company has once again left investors wanting more after earnings. While I am inclined to attribute the sluggish financial performance to a broad weaker-than-expected recovery in med-tech, the greater FDA scrutiny from the company's lead issues is a more troubling development for the next year or so.
Earnings Were No Disaster
I've already read a few summaries of St. Jude's quarter talking about disappointingly weak trends in its earnings, but I'm not really seeing a huge reason for concern. Revenue was down 4% as reported (and barely positive in organic terms), but that means St. Jude missed by a not-so-whopping 1% relative to the average sell-side guess. That's not exactly a pearls-clutcher in my book.
Likewise, I think St. Jude did alright on margins. Gross margin was slightly better than last year, while operating income ticked up 1% (and beat estimates). The company did pretty well on SG&A expense control, suggesting to me that the company will succeed in offsetting a least some of the oncoming medical device excise tax.
CRM Looks Like An Industry Problem...
With St. Jude reporting an 8% drop in cardiac rhythm management (NYSE:CRM) sales (or a 4% decline in constant currency), this is sure to be a talking point. That is a step down from the 2% decline in the second quarter and flies in the face of hopes that CRM was bottoming out.
It also happens to be worse than the 2% decline that Medtronic (NYSE:MDT) reported two months ago. Seeing that Boston Scientifc (NYSE:BSX) was also down 8% this quarter in CRM (and 6% in constant currency), though, I'm inclined to think the market is weaker than analysts had been expecting. Given that other medical device operations like Johnson & Johnson (NYSE:JNJ) haven't exactly been lighting it up this quarter either (granted, JNJ is not in the CRM industry), it looks like this is a pretty general trend.
...But A Warning Letter Is Not
Very much specific to St. Jude, though, is ongoing trouble relating to its leads. Regulators have raised questions about the Optim coating and the FDA is taking a much more direct role in the process now, with St. Jude management indicating that it expects a warning letter for the facility that makes the leads. On top of that, the company is currently enmeshed in a dispute with its partner AorTech.
Although the company gives the appearance of being proactive on this lead issue (I can't immediately recall too many other pre-announcements for FDA warning letters), this could start weighing on the company. First, it's a distraction that management must deal with, and warning letters almost always require money to correct. Second, if St. Jude gets into a dragged-out BSX-like spiral of issues with the FDA, it could impair product launches, and not just in CRM.
Oh, and don't think that Medtronic or Boston Scientific are going to let this opportunity go unexploited; count on their sales forces flogging this issue as long as they can.
Other Businesses Looking So-So For Now
With CRM comprising more than half of St. Jude's business, it certainly shapes the quarterly performance. That said, St. Jude's other businesses didn't help all that much.
Cardio was down 4% as reported, up 1% in constant currency, and up about 6% when adjusting for the termination of some Japanese business. That's not bad, but the big driver here is going to be the introduction of PFO, transcatheter valve, and renal denervation products over the next two years.
I still happen to be in the optimist's camp here, thinking that St. Jude will pull share from Edwards Lifesciences (NYSE:EW) and Medtronic in valves, and maybe taking a lead on Medtronic and Covidien (NYSE:COV) (and whomever buys Vessix or ReCor) in denervation. I also believe that St. Jude can see better growth from FFO/OCT, but investors in rival Volcano (NASDAQ:VOLC) know all too well that this growth has been a long time in coming.
Neuromodulation posted 2% constant currency growth this quarter, while atrial fibrillation was the standout with 13% constant currency growth.
The Bottom Line
Given what I think is solid evidence that the CRM market is not ready to return to primetime (and likely won't be a major grower again for a while, if ever), I'm revising my fair value down a bit for St. Jude.
I'm looking for long-term free cash flow growth of more than 5%, with sales growth in the mid-to-low single digits over the next ten years. While I do believe St. Jude has taken steps towards better sustainable free cash flow margins, investors should note that the company's historical performance here hasn't always been great. I do believe there could be upside tied to share gains and new product launches through 2015, but a fair value in the mid-to-high $40s makes this stock a pretty equivocal pick today.