Description

Boston Scientific Endeavors to Diversify

Boston Scientific is a medical device company that until the first quarter of 2004, was a rather uninspiring company specializing in minimally invasive surgical and diagnostic products. In 2004, BSX brought the Taxus stent to the US market and that milestone changed the face of the company dramatically.

The diverse catalog of minimally invasive surgical and diagnostic products brought the company from a small enterprise generating $1.8 million in 1979 to $3.5 billion in 2003. In spite of this success and growth, BSX did not generate much interest among investors. The market for bare metal stents, catheters, guide wires and other minimally invasive surgical products is competitive and the products are something of a commodity, rather than a brand name product with a wide moat capable of commanding dominant market share and higher margins. BSX did reasonably well and growth was steady but slow. In the most recent 10K BSX admits,that for many of their products, competition is so numerous and fragmented they are unable to list competitors in the document. So while BSX was a nice relatively successful medical device maker, they were limited by the stable of commoditized products and lack of brand awareness from hospitals and doctors. They went so far as to initiate an advertising/PR campaign with a slogan in an attempt to create demand for BSX brand specifically.

The launch of the Taxus drug eluting stent(DES) changed all that for the company. They had a brand name product. Surgeons showed a preference for Taxus and it quickly gained on JNJ’s Cypher and took nearly 70% of the market share.BSX had the satisfaction of beating JNJ and their Cypher stent even though Cypher was brought to market nearly a year ahead of Taxus. From January 2003 until early summer 2004, BSX’s price per share nearly doubled as revenue climbed from $3.5 billion to $5.6 billion mainly on the success of the Taxus stent.

2004 2003 2002 2001
Growth, revenue 61.8% 19.1% 9.2% 0.3%
Growth, gross income 72.2% 22.7% 16.8% -4.3%
Gross margin 77.0% 72.4% 70.2% 65.6%
operating margin 28.0% 20.1% 20.9% 3.7%
Net margin 18.9% 13.6% 12.8% -2.0%

Unfortunately, by the fall of 2004, what had been the savior of a rather mediocre, faceless medical device maker, became BSX’s Achilles heel.

In the summer of 2004, the stent had to be recalled for inflation problems related to a faulty weld. The problem was addressed and fixed expeditiously, but after a short climb at resolution of the recall, BSX continued to decline and for most of 2005 was notable for reaching new 52 week lows on a regular basis. The biggest blow to the company was a steadily eroding market for Taxus as JNJ’s Cypher gained market share. At the 2005 cardiology conference JNJ presented informal trials that showed Taxus causing more post operative complications and no clear advantage in restenosis rates. From that point, Taxus market share began to decline until the two were nearly equal.

When sales began to slow in 2005, the stock lost momentum.

In the first 9 months of 2005, revenue has slowed significantly and the stock has fallen far out of favor:

9/05 6/05 3/05 12/05
Growth, revenue -6.6% 0.1% 0.9% 8.0%
Growth, gross income -7.3% -0.9% -0.1% 8.4%

And as sales looked like they were permanently stalled, the price has remained depressed.Wall Street has not been in love with BSX in 2005. What was an overpriced growth stock has languished on the new 52 week lows lists for much of the year.

Why the review of history and why bother considering buying a company that relies so heavily on one product?

On December 5, 2005, BSX unexpectedly announced it was entering a bid for medical device maker Guidant. The bid was more than $3 billion higher than the most recent JNJ offer. JNJ and Guidant(GDT) had been in talks for nearly a year. The deal had been finalized between them until GDT was forced to recall both pacemakers and defibrillators(cardiac rhythm management or CRM) early last summer due to conduction malfunctions)shorting). JNJ withdrew its offer, but returned to the table with a significantly lower bid. BSX took the opportunity to whisk the company out from under the JNJ deal. GDT apparently happy with its change in fortunes is seriously considering the offer and JNJ has not expressed interest in raising its bid.

As BSX noted in the conference call concerning the acquisition, Wall Street will pay a premium for a well-diversified high margin medical device company and that is just what they intend to become with the acquisition.

This merger represents an opportunity to buy a company that will likely emerge as one of three big players in the rapidly growing cardiac device market(BSX expects to be second to Medtronic).The most important and profitable cardiac rhythm management devices (CRM) are the defibrillators and pacemakers. Sales are estimated to reach more than $9 billion this year and increase to over $10 billion in 2006. There are 3 major manufacturers and distributors in the US--Medtronic, Guidant and St. Jude--which have 95% of this market. There are two minor manufacturers in Europe.

Pacemakers and defibrillators are brand name products with wide moats and the threat of competition is remote. New entrants into the market are unlikely due to the high cost of R&D and the patents already in place. BSX is looking to relieve the burden on Taxus(40% of sales) and convince Wall Street they are worth more as a well-diversified cardiac care company. BSX predicts Taxus will drop to 25% of sales post-merger.

The market is split between the three companies in the US--Medtronic, Guidant and St Jude--is as follows:

2004 sales and percentage of market

MDT $4.6 billion 58%
STJ $1.6 billion 20%
GDT $1.8 billion 22%

Total 2004 sales of CRM devices was $8 billion

It is estimated sales in 2005 will be over $9 billion and should be over $10 billion in 2006. Growth in defibrillators alone has seen an increase from 21,000 devices implanted in 1995 to almost 300,000 in 2005. Long term it is estimated this market will increase at least 13% per year conservatively overall and the defibrillator market will grow at 16-20%.

One recent impetus to sales has been from the results of trials conducted by Guidant demonstrating that for advanced heart failure patients with desynchronized heart contractions, the addition of resynchronization therapy to optimal drug treatment reduced the combination of death and hospitalization, the FDA approved an expanded indication for Guidant’s CRT-D defibrillator in September 2004.Why is this important? FDA approval is necessary for the device to be covered by insurance in expanded or previously off-label uses. This approval expands the labeling to all patients with moderate-to-severe heart failure and that translates to thousands more patients now covered. Importantly, based on these results Medicare & Medicaid Services expanded national coverage to patients at risk for sudden cardiac death in January 2005.There has been speculation that Medicare will renege on this coverage as it becomes more expensive every year and more patients are eligible for coverage. It is impossible to predict what Medicare will or won’t cover year to year, but at present the reimbursement appears to be firm.

About 450,000 people die in the United States each year from sudden cardiac arrest, with 5 million suffering some degree of heart failure.

Defibrillators can cost more than $25,000, and pacemakers more than $5,000. The products are high priced and high margin.

When BSX announced its bid for GDT, they cited under-penetrance with strong growth potential in CRM devices as a rationale for the offer.Pacemaker sales have slowed, but implantable defibrillators sales rose 24% in 2004.

If 2006 CRM sales are $10 billion, GDT or BSX (if the merger is successful) might expect to see $2.3 billion from defibrillators and pacemakers alone(BSX predicts EBITDA of $3 billion in 2006 post acquisition).

Returns on Capital and Earnings Yield

BSX has not been driven by organic growth, instead relying on acquisitions to broaden offerings and increase revenue. The returns from these acquisitions has been acceptable,but with the launch of Taxus, returns on capital improved dramatically. They have spent $2.1 billion in 4 years on acquisitions and returns on capital in 2003 were nearly 13% (pre-Taxus calculated as EBIT(1-t)/D+E))and rose to 21% post-Taxus


Acquisitions

2001
total $675 M

2002
total $187 M

2003
total $25 M

2004
total $815 M

2005
total $380 M

Grand total is $2.1 billion in four years. But it pales in comparison to the planned $25 billion acquisition of GDT. Returns to investors measured in several ways(ROIC, ROA and ROE) have been reasonably good and increasing over the last three years. ROIC was measured in two ways:the method used by Greenblatt and the ROIC using after tax EBIT. The biggest increase was seen after Taxus was brought to market

12/04 12/03 12/02 12/01
ROE 26.4% 16.5% 15.1% -2.7%
ROA 13.0% 8.3% 8.4% -1.4%
ROIC [(EBIT*1-t)/D+E] 21.2% 12.9% 12.6% -15.9%
ROIC(Greenblatt) 167% 77% 84% 45%

Share Dilution Rate 1.10% 0.42% 1.51% 1.35%

Earnings yield in 2004 was 8.3%. Currently, BSX is a company that yields earnings in excess of the ten year treasury and has high returns on invested capital.

ROIC increased markedly in 2004 largely due to Taxus sales. In 2004, U.S. net sales increased by $1,578 million, or 82 percent, as compared to 2003. The increase related primarily to $1,570 million in sales of Taxus,launched in the U.S. late in the first quarter of 2004.

Growth for BSX will be considerably slower without a new blockbuster product. In the 3rd quarter 2005, Taxus sales were down 19% from the same quarter in 2004 and revenue declined 5%. The good news was most of the other product segments experienced double digit gains. Unfortunately, Taxus is 40% of sales at present.

The move into CRM devices should give BSX a wide-moat high margin product that will propel growth in the future. BSX is warning the deal will be dilutive for nearly two years as the result of an increase in shares of approximately 50%(GDT shares would be exchanged for 1.4 shares of BSX at current prices).There will be 50% dilution from increased number of shares. That will be offset by an increase in EBITDA, EBIT and net income. EPS will likely see 10% or more declines the first year after the acquisition as the result of increased number of shares. BSX has been buying back shares(25 million the first 9 months of 2005) and 37 million more shares are currently authorized for purchase. Continued buy backs, if they proceed, could offset dilution of the Guidant shares by a little less than 10%.

By 2008, the merger is estimated to become accretive. In the meantime, revenue growth should show solid increases. The bottom line is predicted to decline from share dilution and increased interest expense. The company has not offered guidance on 2006 EPS that includes the acquisition. BSX is expecting possible cost savings and synergies of around $400 million but is careful to state these may not be realized and the merger with Guidant is purely for growth in the CRM market.

Debt and Interest Coverage

Current Debt and Rates

** $1,375 million of commercial paper outstanding an average interest rate of 3.73 percent
** $280 million outstanding at 2.44 percent.
** outstanding borrowings of $2,367 million at a weighted average interest rate of 3.38 percent.

The Guidant acquisition is for a total of $25 billion--$12.5 billion in stock and $12.5 billion in cash. GDT currently has $2.7 billion in cash and BSX has $900 million in cash.

The financing is in place and the company expects to retain its investment grade rating and anticipates no substantial increase in cost of debt

**$1 billion 5 year term loan
**$2 billion 5 year revolving loan
**$7 billion bridging loan

The bridging loan may be drawn down and paid partially with the $3.6 billion in cash. The divestiture of the endovascular/cardiac vascular surgery segment is estimated to bring $3 to $4 billion and can be applied against the bridging loan. The rest will be covered with debt capital market financing. Those amounts have not been estimated.

The mix of debt/equity of 40/60 will not change and BSX does not expect to be issuing more equity to pay for the acquisition

Net cost of GDT after cash and divestitures will be around $19 billion

BSX estimates the amoritizable goodwill be $700 million and be taken over 20 years($35 million per year)

BSX expects the debt to be paid in its entirety by 2009. The merger will be accretive in 2008 with revenue estimated at $12 billion--nearly double current ttm revenue by 2009. That is a CAGR of 17.3% in revenue if they can realize $12 billion by 2009

It may be optimistic to expect pay down of $10 billion in debt in 4 years. However, even a partial pay down is acceptable. BSX after tax cost of debt is expected to be around 4% with a cost of capital of 7.5%. The spread between the average ROIC and the cost of capital is still positive (18%-7.5%=10.5%)and under these terms, financing with the current debt to equity mixture should continue to be generate reasonable returns.

To pay off $10 billion in debt in 4 years the company would need to average $2.5 billion in debt repayment per year. Current cash flows to firms for GDT and BSX are $367 million and $687 million respectively. At growth rates in revenue of 18% for 5 years with conserved margins, FCFF will increase to nearly $2 billion by 2009. The company has not said where cash other than free cash flow would come from to pay off the debt. Some of it certainly can be paid with free cash flow. In any event, carrying some of this debt is not necessarily troubling even if it extends beyond 2009. Partial repayment over the next five years would be desirable as interest rate payments would decline and margins improve.

Trailing twelve month interest payment were $78 million and the interest coverage ratio is a comfortable 21.6. Assuming total debt of $10.5 billion post acquisition(BSX supplied figure) at an average of 4% rates, the annual interest is $420 million. The interest coverage ratio would then be about 7%(assuming EBITDA of $3 billion). Certainly a much less comfortable cushion but not distressed.

Earnings Estimates

BSX has predicted in 2006, the merger will increase EBITDA to $3 billion(current ttm EBITDA is $1.9 billion).
They are not offering guidance on earnings per share in 2006 other than to say it will be diluted.

If EBITDA is $3 billion, after interest at $420 million and estimated depreciation of $300 million net income before taxes is is $2.22 billion. Assume a corporate tax rate of 35% and net income is $1.43 billion or $1.20 per share(10% decline). If earnings can grow at 13% in 2006 to 2007, the EPS in 2006 would be $1.35 and by 2008 could be accretive.

The acquisition will cost $25 billion.It represents an immediate infusion of $2 to $3 billion in revenue that has the potential to grow at least 13% per year, but probably more depending on the mix of CRM devices sold. Defibrillator sales are increasing 16% to 20%(pacemakers are somewhat lower). BSX will have to sell some of the vascular business but will be able to keep rights to the GDT drug-coated stent under development(DES). Cardiac and vascular is $292 M in revenue in 2004 and angioplasty was worth $452 M(total is $744 M). It is not possible to say how much of this will have to be divested. BSX estimates $3 to $4 billion in sales realized from divestiture. Some of the profit from the divestiture may be used to pay down the loan according to management.


Comparable Ratios

There are only three companies currently splitting the CRM device market(US companies only). The market is growing rapidly and BSX predicts 16-20% in the defibrillator segment(pacemakers are not growing as rapidly) and 13% growth overall. They intend to concentrate their efforts in the high power(HPR=defibrillator) market. BSX will of course keep pacemakers. The HPR market is under-penatrated with the new expanded coverage. Of the three companies, BSX is selling at a discount at present. With the successful acquisition of GDT, current shares of BSX could be considered to be trading significantly below the multiples the market accords to the other diversified medical device companies.

Medtronic(MDT)

EBIT ttm 2299.4 million
EBIT/share 1.92
price/EBIT 30.3
EPS ttm 1.53
P/E 37.8
EV 73518.8
EV/EBIT 31.8

St Jude (STJ)

EBIT ttm 708.2 million
EBIT/share 1.94
price/EBIT 26.3
EPS ttm 1.36
P/E 37.5
EV 19510.6
EV/EBIT 27.5

Guidant (GDT)

EBIT ttm 821.1 million
EBIT/share 2.53
price/EBIT 26.4
EPS ttm 1.68
P/E 39.8
EV 22060.4
EV/EBIT 26.9



Sept quarter for GDT was notable for a significant decrease in EBIT due to product recalls and declining sales. It was around $100 million less than expected.GDT expects the current quarter to show some recovery of lost market share from recalls(dropped nearly 30%)

Boston Scientific (BSX)

EBIT ttm 1787 million
EBIT/share 2.18
price/EBIT 11.5
EPS ttm 1.34
P/E 18.62
EV 23011.5
EV/EBIT 12.9

Johnson & Johnson (JNJ)

EBIT ttm 13587 million
EBIT/share 4.50
price/EBIT 13.55
EPS ttm 3.24
P/E 18.79
EV 186460.1
EV/EBIT 13.7

Looking at the ratios comparable medical device companies are trading at, shows BSX to be at a discount at the current price per share. JNJ has been included as there is some speculation if they lose GDT, They may make an offer for St Jude. JNJ understands the potential for growth in the CRM market(as evidenced by the initial interest in GDT) and may look to enter the field by an alternate acquisition. JNJ is a better value than MDT, GDT and STJ, but not as undervalued as BSX.

Growth for BSX Apart From GDT

In spite of the slow growth in 2005, BSX is not entirely without prospects for increasing revenue from its existing business in 2006. The decline in Taxus appears to be stabilizing and JNJ has admitted the Cypher stent was not statistically different from Taxus in post op complications. In 2006, BSX expects to launch the second generation Taxus stent, Liberte, in the US. Liberte is intended to offer increased flexibility and stent conformability, better vessel coverage and support, and enhanced trackability. These are the characteristics that made Taxus the preferred stent over Cypher at launch. The improvements may win surgeons back who have switched to Cypher.

Other business segments are showing higher growth than the Taxus. Endosurgery, urology and neuromodulation contributed 15%, 29% and 150% respectively in the last quarter. Neuromodulation is a relatively new segment launched in June 2004.

Angiotech(the drug coating paclitaxel belongs to them)is anticipating $3.1 to $3.3 billion in Taxus stents worldwide in 2006. The first 9 months of 2005 show sales at $1,365 million compared to $1,068 million for the same period in the prior year. Taxus 2005 sales may approach $2.5 billion(worldwide stent sales predicted to be $5 billion). BSX share for the first 9 months of 2005 was 61% which dropped to the mid 50’s in the last quarter. If the market share stabilizes at approximately equal shares for JNJ and BSX, 2006 earnings from Taxus will be around $3 billion world wide--an increase in revenue of 20%. 2006 world-wide coated stent sales are estimated to increase 20% to $6 billion. While revenue growth is no longer 60+%, it is still likely to be respectable at around 20%.

DES competition is set to increase in 2007. Medtronic is launching Endeavor and Abbott will bring their own stent to market in 2008 or 2009. MDT does not have rapid release technology(which belongs to JNJ and BSX) at present which makes their product less likely to take dominant market share. BSX has predicted Taxus may eventually be reduced to a 42% market share with the advent of MDT and Abbott product.

The future increased competition in the DES market makes it critical that BSX find some other engine for growth. Accretive earnings in 2008 from a GDT acquisition would be well timed.

Risks

The Guidant deal falls apart
Medicare changes reimbursement for CRM devices
Law suits from the GDT 2005 recall exceed BSX expectations

Catalysts

The Guidant acquisition goes through
Expanded coverage for CRM devices creates underpenetrance
Liberte stent and a second platform acquired with GDT give BSX dominant DES share
A well-diversified medical device company will command higher multiples
Currently valued at ratios well below competition

Catalyst

The Guidant acquisition goes through
Expanded coverage for CRM devices creates underpenetrance
Liberte stent and a second platform acquired with GDT give BSX dominant DES share
A well-diversified medical device company will command higher multiples
Currently valued at ratios well below competition