Description
Boston Scientific – BSX -
Boston Scientific is a compelling investment opportunity for those willing to take a 3 year horizon on an investment in the company at current levels. This is the second write up on BSX as kitkat919 originally suggested that BSX was an attractive long on Dec 25, 2005 (see his write up in VIC). At that time, the price was $25.84. The company had “won” the bidding for Guidant (we thought they overpaid – but as discussed below, if you look at it from point of view of BSX it wasn’t (totally) irrational given the actual facts and circumstance). In fact, around the time of the original write up, we shorted BSX, but ended up covering in the $15 range in July of 2006. Despite what we viewed as still solid long-term prospects for BSX (a 4 to 5 year horizon at that time), we were more comfortable being short than long this company at that time.
In the last year, BSX has continued to fall in price. At its current price of just over $17 per share, BSX has fallen an additional 33% in the last year since kitkat’s original writeup. Meanwhile the Guidant deal has closed and the BSX business (which was scarily dependent on primarily the drug eluting stent business is now much more diversified). In 2004, on the back of enthusiasm for rapid growth in Taxus sales, BSX hit its all time peak of $45.12 on May 27 2004. Relative to that lofty price, BSX has fallen about 62%. However, in the last two years, the company as grown and become a better business.
Michael Steinhardt had this interesting concept of identifying his “Variant Perception” In this construct, you should be able to explain in about 2 minutes or less the merits of an idea by following the following four points: 1.) The idea (in brief) 2.) The consensus view 3.) The variant perception (i.e. our differing view) 4.) the catalyst or trigger event that would make the consensus view change and (hopefully) come closer to a different perception (negating the previous consensus).
I am going to take a shot at using this construct to summarize our thesis on BSX and why we currently think BSX is a compelling long.
1.) The idea
BSX is a diversified medical devices company. Originally founded in 1979, the company was formed around the idea of using innovation to develop and market medical products that would lead to less invasive medical procedures and solutions that would lead to better outcomes for patients. Net sales increased from $1.8 million in 1979 to $6.3 billion in 2005 through both acquisitions and organic growth. Today, company generates revenues from several business segments. The company primarily reports revenues in three business segments (Cardiovascular, Endosurgery, Neuromodulation). However, I am going to further break cardiovascular down into its two principal segments. In summary, Boston Scientific has the following four major business lines today:
1.) Cardiovascular stends and related catheters and products to treat a variety of vascular issues (like obstruction in vessels)
2.) Cardiac Rhythm Management – consists of implantable cardiac devices like pacemakers, etc. that are meant to regular heart beating or restart it by delivering electrical stimulation. Basically, they entered this business mainly with the Guidant acquisition that closed in 2006
3.) Endosurgery – This is a broad category dealing with a whole host of innovative devices covering problems associated with the stomach, colon, pancreas, lungs, prostate, uninary tract, gynecology, oncology, etc (i.e. the major internal body organs and function in the abdomen other than the heart)
4.) Neuromodulation – Related to spinal cord, nervous system, and brain related organs and functions including devices for pain management and hearing devices.
Annualizing the 3Q 2006 revenues, the relative sizing of each of these segments is as follows:
Cardiovascular: $4.720B (stent related revenues represent about 73.5% of this total)
Cardiac Rhythm $1.784B (Guidant business)
Endosurgery $1.360B
Neuromodulation $240M
Total Annualized Revenue: $8.1B
While there are near term issues related to slowing growth rates, product recall/manufacturing related, or adverse studies in one or more of the companies segments (notably drug eluting stents and some recall issue on some of the Guidant devices), medical devices tend to have proprietary characteristics and high value added through design, innovation, and marketing. Consequently, BSX has a portfolio of business that throw off a lot of cash and high gross margins. Specifically, gross margins have averaged in the low to mid 70% range across the company’s product portfolio. BSX spends a tremendous amount of money on its sales and marketing and on R&D (15% of sales) to keep driving innovation which is the ultimate source of long-term value creating in the medical devices segment.
From a long-term holders perspective, the size and opportunity for innovation have been overshadowed by the incredible and rapid success of the drug eluting stent business with the incredibly successful rollout of TAXUS in the first half of 2004. However, BSX has a vast pipeline of innovations, both incremental and also game changing ones. Overtime, a number of these could grow into substantial and profitable additional profit centers. There is still a lot of untapped opportunity for less invasive devices across a host of applications to alleviate human suffering and improve outcomes for everyone involved in the chain.
2.) The consensus view
Best I can tell, the consensus view is extremely negative on BSX for the following reasons:
a.) Growth rates in their biggest business – drug eluting stents have stopped and even started to decline. Recent studies suggest that there may be some adverse effect of drug eluting stents relative to bare metal stents and this could result in cardiologists switching back to bare metal which are more of a commodity. Also, new competition from Abbott and Medtronic could lead to a big shift in market share away from BSX and perhaps J&J as well.
b.) They vastly overpaid for Guidant. Effectively, BSX’s “winning” bid for Guidant valued the company at $27B when Guidant will bring in only close to $1.8B in revenue in 2006
c.) Other segments are too small to really make any different
d.) There are no near term prospect for a return to exciting top line growth so we hate this company
e.) The company has a lot more shares outstanding (as a result of dilution related to Guidant) and a lot more debt as well – this is a riskier play given the leverage. At current prices, BSX has a equity market value of $25.3B – on 1.47 billion shares outstanding) plus net debt of about $7.4B (debt of $8.9B and cash of $1.5B). Relative to about $1.2B in cash flow from operations on an adjusted basis over the last 12 months.
3.) The variant perception
We think BSX is still in the process of assembling one of the best portfolios of any medical devices companies in the world. Specifically related to each of the above points in the consensus view:
a.) While growth rates have significantly slowed in 2006, there are a number of innovations in the pipeline that will make BSX a low double digit grower organically over the long-term. There are still international markets that are significantly underpenetrated and several next generation stents that will add to revenues and reaccelerate growth starting in last 2007 and beyond.
b.) While we agree that they did vastly overpay for Guidant, J&J – a very disciplined acquirer was willing to pay in the low $20 billions for the same asset. The ICD market is another in which there is potential room for significant innovation. BSX management gave a significant amount of the consideration in stock that they likely knew was overvalued at the time. Specifically, BSX paid $42 in cash and $38 in stock for each share of Guidant outstanding. A total of $80 per share. This compared to J&J’s best offer of 71 per share. Since BSX price has fallen since the merger, if you revalue the considerating BSX paid, I comes out to almost exact the same $71 per share.
c.) & d.) while we agree the near term prospects are unenticing, this represents the long-term versus short term arbitrage that can be very attractive when Wall street is so fixated in the near term.
e.) The balance sheet debt will be paid down over time (like a partial LBO model). This debt reduction alone should add about $5 to $6 per share to equity value from current levels.
Catalyst
* getting into late 2007 with some positive developments on the new stent introductions
* fixing some of the ICD issues with the Guidant devices
* continuing stream of innovations in the other segments
* paying down debt
* perhaps asset sales related to certain product lines or divisions to paydown debt more quickly