It was never part of the plan for Boston Scientific (BSX) to have a sudden return to growth in the third quarter (or 2012, for that matter), so it's hard for me to be disappointed by the numbers that the company continues to post. The driving question for investors continues to be whether the company's seemingly endless restructuring moves and acquisitions will give it a better platform from which to grow, and/or whether the transition to new CEO Mike Mahoney will mark a turning point. Though I'm still skeptical, I have to point out that the rewards for success could be meaningful from today's level.
Another Weak Quarter
At the risk of overdoing my skepticism on Boston Scientific, it's hard for a company to disappoint when you expect basically nothing from them. I do wonder, though, whether Boston Scientific has the technology to regain what it has lost in market share over the past year or two.
Revenue fell 7% this quarter, or 5% in constant currency terms, and missed the average estimate by about 2%. Declines were led by the very weak interventional business (down 17% cc) and cardiac rhythm management (CRM), which fell 6% in constant currency. Endoscopy and peripheral were both pretty solid, though, with revenue up 7%.
Boston Scientific also did all right on the profit/margin side of the ledger. Gross margin did weaken about 50 basis points sequentially (on an adjusted basis), but the company has made a lot of progress stripping out SG&A costs. While the company reported a GAAP operating loss, adjusted operating income rose about 15% and seemed to surpass most expectations.
CRM And DES - Holding A Weak Hand In Weak Markets
It's no help to Boston Scientific that half of the company's revenue comes from categories that are not only weak in their own right, but where Boston Scientific is on the wrong side of the fence.
Drug-eluting stent sales fell almost one-quarter, with U.S. sales down more than a third. Now, this whole category is pretty soft (Abbott Labs reported a 6% operational decline in vascular, and 6% growth from the Xience stent platform), but it looks like Medtronic (MDT) is pretty much eating Boston Sci's lunch now with the Resolute stent. An IDE study for Synergy should start by the end of the year, but I'm not sure Boston Sci can win a perpetual game of leapfrog with Abbott and Medtronic.
In CRM, Boston Sci management backed up the idea that the market as a whole declined about 4-6% this quarter, which is unfortunate, as their sales were on the lower end of the spectrum (down 6% cc), with U.S. ICD sales down 9%. That's worse than St. Jude Medical (STJ), and it looks as though the company continues to lose share to Medtronic and/or St. Jude.
The biggest question here is the extent to which the recently-approved S-ICD can change things. I do believe that this could be a potential blockbuster, but the cynic in me asks how long it will be before Medtronic crashes the party if this does, in fact, prove to be a viable product/approach?
Will A Different Strategy Mean Different Results?
Although the CRM and DES markets are in rough shape, Boston Scientific seems to have focused on rebuilding itself away from huge reliance on a small number of markets in favor of multiple shots on goal. Over the next few years, we'll see if that can drive substantially better results.
The company's endoscopy business seems to be doing well -- it was stronger than those of Johnson & Johnson (JNJ) and Stryker (SYK), and we'll have to see how it did relative to Covidien (COV). Likewise, the peripheral and neuromodulation businesses didn't perform badly this quarter, either.
The real question, though, is if the new products and technologies live up to their promise. Can Altair get the reimbursement and acceptance it needs to be a billion dollar-plus opportunity? Will the acquisition of Rhythmia allow Boston Sci to be a player in mapping alongside St. Jude and JNJ, and allow it to build a strong a-fib business? Can the company stand shoulder-to-shoulder with St. Jude and Medtronic in left atrial appendage treatments? Will being fourth to market in transcatheter valve and renal denervation leave enough on the table?
Those are a lot of questions for any company, let alone one that has burned a lot of investors over the years by over-promising and under-delivering.
The Bottom Line
I like turnaround and contrarian stories, and I'd love to lead the charge in declaring that Boston Scientific is underappreciated by investors. Unfortunately, I just can't get past the fact that the company is about two to five years behind its rivals in many of its best new growth opportunities, not to mention the fact that its two largest core markets are still pretty soft.
Right now, I value Boston Scientific at around on $7 per share on the basis of 10% compound annual free cash flow growth and an above-average discount rate. Give Boston Scientific the same discount rate I use for St. Jude, and fair value jumps to about $8.50. Give it the same free cash flow margin in 2022 that I project for St. Jude, and now the fair value moves to about $10. I also acknowledge that my long-term revenue growth target of 3% could be too low -- populations in North America, Western Europe, and Japan are aging, and the company does have some high-potential products coming.
So, like most turnaround stories, it comes down to a question of confidence. If you believe Boston Scientific has gone through its crucible and that new management will deliver on its potential, these shares are likely undervalued by a meaningful degree. I'm not willing to take that leap yet, though I do acknowledge that the price/value/opportunity ratio is getting more and more interesting, even with the declines in CRM and DES today.