Boston Scientific Corporation (NYSE:BSX) is being added to GMI Ratings' Risk List, a series of reports on 13 U.S. and European companies, due to concerns about its board, pay practices, accounting, product safety, and regulatory violations.
Boston Scientific is a maker of medical devices. While the company's history dates to the 1960s, its 2006 acquisition of Guidant Corporation made it one of the world's largest cardiovascular device companies. In its most recent 10-K, the company stresses the importance of strategic acquisitions as a means of ensuring a diverse and cutting-edge product portfolio. In 2011, the company sold its Neurovascular business, which had accounted for 2% of sales, and completed the acquisition of three firms with specific products relevant to its continuing business lines.
While the Guidant acquisition has strengthened the company's product line, it is also widely recognized as highly problematic. Most notably, the company has faced a major controversy relating to the concealment of a defibrillator design flaw by Guidant. By 2010, Boston Scientific had paid $234 million in settlements to affected patients, and in 2011, the company paid $296 million in fines on behalf of Guidant to the U.S. Department of Justice (DOJ) as a penalty for misleading statements to the Food and Drug Administration. About 30 product liability lawsuits are still pending against the company related to this matter, as well as a small number of personal injury suits.
Because the improper conduct by Guidant occurred prior to its acquisition by Boston Scientific, these events may not constitute evidence of unethical behavior at Boston Scientific itself. However, given the central importance to the company of growth through acquisition, the Guidant example raises concerns about the quality of Boston Scientific's due diligence process.
Indeed, the Guidant-related payments of over half a billion dollars provide a vivid illustration of the risk (elucidated by the company in very general terms in its 2012 10-K filing) that its diversification into new technologies could be threatened by litigation related to its acquisitions. Moreover, the Guidant headaches do not appear to be a thing of the past: in December 2011, the company received a Notice of Deficiency from the IRS (which it is contesting) asserting that it owes over $581 million in back taxes for Guidant for 2004-2006. In addition, the DOJ has also filed a False Claims Act case against the company, again related to actions by Guidant; the case will be heard in 2013.
In addition to the Guidant-specific issues, the company's overall high level of merger and acquisition (M&A) activity obscures the transparency of its accounting. Boston Scientific has been rated Aggressive or Very Aggressive on our Accounting and Governance Risk (AGR) rating for the past three years. In this time period, the company has frequently been flagged for a high number of divestitures, acquisitions, and restructurings relative to industry peers. The accounting issues we highlight are concentrated in the balance sheet and suggestive of overvalued assets.
Consistent with the frequent M&A activity, we see a high ratio of goodwill to assets (45% versus an industry median of 11%) and low asset turnover (35% versus 74% for the industry). Also, intangibles are very high relative to peers (31% vs. 7%) and the company's cash ratio, at 15%, is significantly lower than the industry median of 97%. In addition, deferred income tax assets and operating expenses are relatively high. High deferred tax assets sometimes arise from restructuring activity, and also raise concerns about the possibility that they may be overstated while current period expenses are understated.
Moving beyond its acquisition activity, the company is also facing a non-Guidant product liability problem, as 250 suits have been filed against it alleging personal injury associated with use of its transvaginal surgical mesh products designed to treat stress urinary incontinence and pelvic organ prolapse. In terms of traditional governance issues, as well, Boston Scientific has a number of problems.
For instance, there are concerns regarding takeover defenses and board entrenchment. Supermajority voting provisions in the charter and bylaws restrict shareholders from making many meaningful governance changes. Approval of 80% of shares is required to amend an article in the charter relating to directors, and approval of 80% of shares is required to amend sections in the bylaws relating to stockholders' meetings, director nominations, and director removal (with or without cause).
In addition, it is noteworthy that four of the board's eleven directors are long-tenured with at least a decade of service; long tenures may sometimes compromise independence and objectivity. Moreover, three directors are over 70 and a fourth is 69, which may suggest succession planning issues. Additionally, two of the directors are brothers: Chairman Peter M. Nicholas and Finance Committee chair N.J. Nicholas, Jr.
Furthermore, there are signs that the company's executive pay practices may not be optimally aligned with investors' interests. The most dramatic recent example was the very generous package received by J. Raymond Elliott, who served a short term as CEO from 2009-2011. Mr. Elliott became President and CEO of Boston Scientific Corporation in July 2009, succeeding James R. Tobin, who had served as head of the company for more than a decade.
Mr. Elliott's welcome package included a cash signing bonus of $1.5 million, one million shares of deferred stock units (DSUs), non-qualified options to purchase 3.4 million shares of company stock, and a non-qualified option to acquire more than 600,000 shares of additional shares in 2010. His total compensation for the 2009 compensation year was more than $33 million, including almost $30 million in expensed equity awards, as well as perks that included almost $200,000 in personal use of company aircraft and more than $1 million in home relocation expenses and associated tax gross-ups.
Despite this "golden hello" package, which set him just outside the top ten earners in our US coverage universe of 3,300 CEOs for the 2009 compensation year (he ranked 12th), Mr. Elliott ultimately served only two years as CEO of Boston Scientific. Net sales decreased by five percent from 2009 to 2010, or $0.70 per share, according to the company's 2011 proxy, and revenues were between the 25th percentile and the median of the company peer group. In addition, the company unveiled job cuts in 2010, took a $1.1 billion fourth-quarter loss, and agreed to pay more than $1.7 billion to Johnson & Johnson (NYSE:JNJ) in order to resolve three longstanding patent disputes involving heart stents, the largest settlement ever at Boston Scientific. Mr. Elliott announced in May 2011 that he would resign as CEO, and did so effective October 2011.
The mega-grant of 604,348 stock options granted in 2010 as part of Mr. Elliott's welcome package were all underwater as of the company's most recent proxy; however, those options will vest in full and the DSUs will be retained pro-rata to the amount of time served since their award. This means Mr. Elliott could still benefit substantially should the company's stock price improve over the next several years.
In September 2011, Boston Scientific announced that Michael Mahoney of Johnson & Johnson had been named company President and was expected to be named CEO in November 2012, following an interim CEO term by Hank Kucheman, an executive vice president at the company. Mr. Mahoney's welcome package includes a cash sign-on bonus of $1,500,000; an additional sign-on bonus of $750,000; an award of DSUs having a total value of $9,532,570; an equity award having a total value of $7,200,000; an annual base salary of $900,000 with a target cash incentive of 120% of his base salary; a supplementary cash payment of $69,230; reimbursement of up to $90,000 for legal costs associated with negotiating his employment arrangements; and personal use of the corporate aircraft up to $100,000 per year.
In sum, Boston Scientific presents concerns on a range of social, governance, and accounting factors. Prudent investors will likely wish to subject the company to increased levels of scrutiny and engagement for some time to come.
Top Institutional Holders (Source: Yahoo! Finance)
*Value shown is computed using the security's price on the report date given.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.