Edwards Lifesciences: Priced For Perfection
Summary
- Edwards Lifesciences is a global leader of patient-focused medical innovations for structural heart disease as well as critical care monitoring.
- The company not only can expect high growth rates in the years to come, it also has a wide economic moat around its business.
- But, right now, the stock is priced for perfection.
When searching for companies, that could have a wide economic moat, I often screen for different metrics. These are metrics like high – and consistent – growth rates, stable margins, outperformance of a stock and high RoIC as well as RoE. And one of the companies that seems to perform great at every metric is Edwards Lifesciences (NYSE:EW). While this is not enough proof for a wide economic moat, it is reason enough to take a closer look at Edwards Lifesciences.
Business Description
The company was founded over six decades ago by Lowell Edwards and until it was spun off on April 3, 2000 as an independent corporation and began trading on the New York Stock Exchange, it was part of Baxter (BAX). Today, Edwards Lifesciences is a global leader of patient-focused medical innovations for structural heart disease as well as critical care monitoring and has about 14,000 employees around the world. The company develops, manufactures, and markets cardiovascular products and is the world’s leading manufacturer of heart valve systems and repair products used to replace or repair a patient’s diseased or defective heart valve.
In fiscal 2020, Edwards Lifesciences generated $4,386 million in revenue, which was an increase of 0.9% YoY. And although Edwards Lifesciences could still increase its revenue, these are rather disappointing growth rates for the company. Similar to many other businesses around the world, Edwards Lifesciences was also impacted by COVID-19: Many procedures were postponed during lockdowns as hospital capacities were needed for COVID-19 patients.
While the top line could increase slightly, operating income declined from $1,147 million in fiscal 2019 to $898 million in fiscal 2020 – reflecting a decline of 21.7%. Diluted earnings per share also decreased from $1.64 in fiscal 2019 to $1.30 in fiscal 2020 – a decline of 20.7% YoY. And while the company could improve its gross margin from 74.4% to 75.4%, operating margin decreased from 26.4% to 20.5%, and net income margin also declined from 24.1% to 18.8%.
(Source: Annual Report 2020)
Net sales are split by four categories or four reporting segments:
- Transcatheter Aortic Valve Replacement: This is by far the most important segment for Edwards Lifesciences and generated $2,857 million in revenue in fiscal 2020. In a difficult year 2020, the segment could still report 4.4% YoY growth. The company is a global leader in transcatheter heart valve replacement technologies designed for the minimally invasive replacement of heart valves – like the Edwards SAPIEN family of valves.
- Transcatheter Mitral and Tricuspid Therapies: This segment develops transcatheter heart valve repair and replacement technologies designed to treat mitral and tricuspid valve diseases. Many of these products are only in early development right now, but the PASCAL transcatheter valve repair system is for example commercially available in Europe. Therefore, the segment could only report $41.8 million in revenue, but 48.5% YoY growth in fiscal 2020.
- Surgical Structural Hearth: In fiscal 2020, this segment generated $762 million in revenue, which is reflecting a decline of 9.5% YoY. This segment produces surgical tissue heart valve products like the Carpentier-Edwards PERIMOUNT pericardial valve platform.
- Critical Care: In fiscal 2020, this segment generated $725 million in revenue, and this segment also had to report a decline of 2.0% YoY. This segment is developing hemodynamic monitoring systems, which play an important role in enhancing surgical recovery.
The most important market for Edwards Lifesciences is still the United States. In fiscal 2020, the company generated $2,517 million in revenue in the United States (about 57.4% of total revenue). About 22% of revenue are generated in Europe ($974 million) with about 10% of revenue being generated in Japan as well as in “rest of world”.
Growth Potential
We mentioned above that fiscal 2020 was a rather difficult year for Edwards Lifesciences. Nevertheless, the company reported impressive growth rates during the last decade. Since 2011, revenue increased with a CAGR of 11.27%, and earnings per share increased even with a CAGR of 16.46% - despite the decline in 2020. And free cash flow – one of the most important metrics in my opinion – also increased with a CAGR of 12.51%.
(Source: Author’s work based on numbers from Morningstar)
We not only saw very impressive growth rates in the recent past, but according to studies, the segments could also see high growth rates in the years to come. First of all, the growing adoption of minimally invasive surgery (MIS) will most likely reduce the overall hospital stay of patients, which is going to reduce healthcare expenditures. For that reason, it seems likely that hospitals and other healthcare institutions will move more and more towards minimally invasive surgery to save costs.
Additionally, the rising number of patients suffering from cardiovascular diseases like heart failures, coronary artery diseases and hypertension is one of the trends leading to a growing market over the mid-term (or maybe even long term). Cardiovascular diseases lead to improper functioning of aortic valves, and that is leading to an increased demand for efficient valve replacement procedures.
According to the above-mentioned analysis, the global Transcatheter Aortic Valve replacement market (which is contributing the biggest part of revenue for Edwards Lifesciences) is anticipated to rise with a CAGR of 22.6% over the next few years.
(Source: Grand View Research)
Edwards Lifesciences is also expecting its TAVR could replace surgical valve replacement over time, a procedure which is required by around 400,000 people in the United States every single year. The reason TAVR should become dominated is the much lower risk of death, stroke or rehospitalization.
Wide Economic Moat
While such high expected future growth rates are great, there is also a major risk involved: it attracts competition and the companies therefore need high levels of defensibility in order to maintain such high growth rates. And aside from new competitors, that could get attracted by high growth rates, Edwards Lifesciences is also competing with major players like Medtronic plc (MDT), Boston Scientific Corp. (BSX) and St. Jude Medical Inc. – which is now a part of Abbott Laboratories (ABT). And especially Medtronic is moving aggressively into this market.
Edwards Lifesciences is operating in a market that is highly regulated and requires a lot of upfront research and developments, which is leading to high barriers to entry for new companies. New companies being able to enter this sector is therefore not as easy as it might seem at first. And even if new competitors should introduce competitive products to the market, we still have high switching costs – as with most medical products. For the medical professionals, there is often a steep learning curve involved. All people involved in the procedure have to learn to use the products and once they are trained on using Edwards Lifesciences’ products (and maybe are convinced these are the best), they might be hesitant to switch.
Of course, the other major competitors mentioned above see similar tendencies and can create similar switching costs. However, when looking at the different numbers and metrics, neither Medtronic nor Abbott Laboratories seems to be able to match Edwards Lifesciences. Aside from the impressive growth rates mentioned above, Edwards Lifesciences can also report either stable or increasing margins. While gross margin is fluctuating between 70% and 75% with an upwards tendency, operating margin could improve from 17.9% in fiscal 2011 to 30.0% in fiscal 2020.
(Source: Author’s work based on numbers from Morningstar)
And aside from stable or improving margins, Edwards Lifesciences could also report extremely impressive return on invested capital metrics during the past decade. Not only was the RoIC above 14% in every single year, the average RoIC was 19.82%, which is a very high number.
And just as a sidenote, I like to mention Edwards Lifesciences’ credo. In the past, I mentioned in two different articles about Johnson & Johnson (JNJ) as well as 3M Company (MMM) the book Built to Last: Successful Habits of Visionary Companies written by Jim Collins and Jerry I. Porras. One of the characteristics of these visionary companies is a focus on “more than profits”, and Edwards Lifesciences’ credo also seems to point towards such a characteristic. This is certainly no “proof” that Edwards Lifesciences has a wide economic moat, but it is another strong hint for a high-quality business.
(Source: Edwards Sciences J.P. Morgan Presentation)
Balance Sheet and Share Buybacks
Edwards Lifesciences has also a very healthy balance sheet. On December 31, 2020, the company had $595 million in long-term debt. Compared to a total stockholder’s equity of $4,574 million, we get a debt-equity ratio of 0.13 – a very low ratio. And when comparing the outstanding debt to the operating income in fiscal 2020 ($1,316 million), it would take less than half a year to repay all the outstanding debt.
When looking at the asset side, the company had $1,173 million in goodwill on its balance sheet. And while goodwill is never good, we also have $1,183 million in cash and cash equivalents on the balance sheet. Additionally, the company has $219 million in short-term investments and $802 million in long-term investments. Summing up, we should worry neither about solvency nor liquidity.
(Source: Seeking Alpha Charting)
And while Edwards Lifesciences is currently not paying a dividend (and as far as I can tell, management does not intend to pay a dividend in the foreseeable future), the company is using some of its free cash flow to repurchase shares. Since 2005, Edwards Lifesciences decreased the number of outstanding shares from 777 million to 632 million. In the last few years, the company reduced the number of outstanding shares about 1% annually.
Intrinsic Value Calculation
I mentioned above that Edwards Lifesciences can expect to grow with a high pace in the years to come, and due to the wide economic moat, the company is protected against competitors. But in order to be a good investment, the stock also has to trade for a reasonable price. Right now, Edwards Lifesciences is trading for a P/E ratio of 65 (when using the TTM GAAP numbers). When using the company’s expected adjusted EPS for fiscal 2021 (between $2.00 and $2.20), we get a forward P/E ratio between 43 and 39. And while the forward P/E ratio seems to be much better, both numbers are extremely high P/E ratios, that should make us cautious as investors.
(Source: Edwards Sciences J.P. Morgan Presentation)
Of course, growth expectations for the years to come are also rather high, and high growth expectations justify high P/E ratios. And here, we see the limitations of simple valuation metrics – we can’t really adjust for expected growth in the years to come. Instead, I usually use a discount cash flow analysis to determine an intrinsic value for the stock. As basis for my calculation, I often take the free cash flow of the last four quarters. However, in case of Edwards Lifesciences, I don’t think fiscal 2020 is representative of the business, and instead, we use the free cash flow of fiscal 2019.
In order to be fairly valued, Edwards Lifesciences would have to grow 19% annually during the next decade followed by 6% growth till perpetuity. I never use higher growth rates for perpetuity as we don’t know what will happen in a decade from now, but if we assume that Edwards Lifesciences can grow 7% till perpetuity, the business would still have to grow 15% annually during the next decade in order to be fairly valued (assuming 10% discount rate).
In order to determine if these growth rates are realistic, we can look at analyst’s expectations for the years to come. According to Seeking Alpha Earnings Estimates, analysts on average are expecting revenue to grow with a CAGR of 12.66% until 2025 and earnings per share are expected to grow with a CAGR of 20.26% until 2025. However, this growth rate is from a very low fiscal 2020 basis, and as we didn’t use the fiscal 2020 numbers in the calculation above, we also should not use these growth rates. Between 2021 and 2025, earnings per share are expected to grow with a CAGR of 11.57%.
(Source: Seeking Alpha Earnings Estimates)
When considering these growth rates, 15% annual growth during the next decade seems very optimistic (let alone 19%). Additionally, we can look at past growth rates to determine if 15% growth seems realistic.
CAGR | Since 1996 | Since 2010 | Since 2015 |
Revenue | 7.15% | 11.71% | 12.01% |
Net Income | 9.82% | 14.21% | 10.70% |
And once again, it seems like 15% annual growth for the bottom line is very optimistic and not in line with past growth rates. Of course, one could assume higher growth rates for perpetuity, and this might seem reasonable. Nevertheless, we have to include some margin of safety and not calculate with the most optimistic numbers as we never know what will happen. And in my opinion, the most optimistic assumption is 15% growth for the next decade followed by 6% growth till perpetuity. This leads to an intrinsic value of $67.31, and Edwards Lifesciences is therefore overvalued. The stock is not so expensive, that one should short the stock (especially as Edwards Lifesciences) is a high-quality business, and shorting such companies can be very dangerous (except when the stocks are extremely overvalued).
Conclusion
It seems easy to be bullish about Edwards Lifesciences: the company is reporting stable or increasing margins, very impressive return on invested capital, has a wide economic moat and a market that is growing with a very high pace. But despite all positive aspects, the share price should still reflect the expected cash flow in the years to come, and Edwards Lifesciences is priced for perfection at this point.
This article was written by
Analyst’s Disclosure: I am/we are long MMM. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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