By Ryan Barnes. Edited By Douglas A. McIntyre
Boston Scientific Corp (BSX) – Price $17.12; Break-up Value $18.11
Boston Scientific has seen its stock pummeled under the dual weights of an industry with a cloudy future and a “questionably intelligent” acquisition in Guidant last year. Medical device makers were the golden children of the healthcare world a few years back, with stocks like BSX, Zimmer (ZMH), and St. Jude (STJ) all showing strong growth in the hot niche area at the time. Now the picture is changing, with the safety of devices such as the Taxus stent being called into question. Litigation had been confined to intellectual property squabbles amongst the various competitors in the space, but when medical efficacy & safety concerns come into play, the potential numbers get much larger and the stock gets a lot scarier to many potential investors.
Boston Scientific also faces increasing competitive threats, as other players will be entering the U.S. space within the next 18 months at the latest. This will obviously put downward pressure on both prices and margins.
Operating expenses at Boston Scientific have risen dramatically since the merger, with SG&A as a percentage of sales rising nearly 6 points in the past year. They also recorded a massive $4b of in-process R&D related to Guidant. The only way to truly tell if this research IP is worth that much is to wait it out, as the only folks that might know for sure are all insiders. For the sake of our analysis we’re going be very conservative and assume that this amount might be slightly inflated to take some pressure over the ugly $12b in goodwill left over from the merger. We have included a breakout of the R&D at $2.5b aside from the run-rate value of the cardiac business purchased from Guidant.
Will Boston Scientific’s chart start to look more like Medtronic over time? Will the growth cycle for medical devices start to resemble major pharma more closely? The answer to both questions could easily be yes. But let’s for a moment take the 10,000 ft. view. America leads the world in heart disease (why not, we lead in everything else), and given the age demographics in the U.S., we could be in the 2nd or 3rd inning of a nine-inning affair.
Boston Scientific has been very adamant about the safety of their drug-coated stents thus far; they are even sponsoring a key clinical trial whose results we’ll have in about a year. In the meantime we are going to assume that the safety concerns will not crush the stent business. But given the fact that the stent group is by far the company’s largest, the concerns have effectively eliminated any premium BSX stock once had. For the sake of our analysis we will look at the salable value of the remaining businesses, which include the Cardiac Rhythm segment acquired from Guidant, the strong and steady Endosurgery segment, the Cardiovascular segment minus the stent business, and the red-hot neuromodulation group, the latter of which is small but growing in excess of 50% per year. These are all strong segments that if measured alone, deserve price/sales multiples in line with peers like St. Jude and Medtronic.
The company holds a lot of debt, but the interest rates are moderate at just above 6%. Of course, they were only 3.3% last year, and they’ve been put on negative watch by rating agencies. They should be able to handle any step-ups in debt covenants with operating cash flow running near $2b annually, and certainly shouldn’t have to issue any more debt which would be costly given the operating environment.
In our segment breakdown, we are valuing the Endosurgery group at a blend of the P/S valuation for MDT and STJ of 4.5x sales, giving this segment a value of $6 billion. The smaller portion of the Cardiovascular segment is valued at the same multiple due to the similar competitive environment, margins, and revenue growth, and would be worth just over $5b.
The up-and-coming neuromodulation segment deserves a premium valuation, and we’re giving it one at 6x sales. Since it is currently a small source of revenue ($234m in ’06), it only brings $1.4 billion to our total and would probably be sold outright to a competitor rather than spun off.
Now to the nitty-gritty of the core businesses. The CRM business acquired from Guidant are pretty close in profile to St. Jude’s, and we see no reason to not prescribe a similar multiple of 4.3x sales. We’ll be dealing with Guidant’s debt in a moment, but just based on operating figures, Guidant had some good things going and more in the works (assessed in our R&D figure). This segment would bring another $9.2 billion to our break-up value – a far cry from the $21b (net of cash) purchase price, but it pays to follow the conservative line in a break-up study of a research-based company like BSX.
We’ve discussed the stent group at length already, and eventually we have to give it a valuation that assess the concerns without ignoring the fact that the bad news could blow over in time, and the segment is still producing $3b plus a year in revenues. To deal with the current weakness we’re valuing the group at a paltry 2.5x sales, far below competitor and industry averages. This values the stent business at $9.2 billion, and after subtracting the LT debt figure and net of current accounts, the total break-up value for Boston Scientific comes to $18.11 per share. This per share figure deserves a big asterisk to the effect that if clarity in the stent business improves (the company is giving us no real guidance for FY 2007), the valuation should be allowed to trend back towards industry averages, which would add $2.50 to $3.50 per share to our break-up figure. Normally we would not play out “what if?” scenarios in this type of analysis, but in this sector safety concerns often disappear as fast as they arrive, and if the growth rates of the past return to the stent business, valuations start to change in a big hurry.
Ryan Barnes
Ryan Barnes has over 10 years’ experience in portfolio management and investment research, covering equities, fixed income, and derivative products. Ryan spent the past 5 years working as an institutional trader & manager for high-net worth investors, working with Merrill Lynch, Charles Schwab, Morgan Stanley, and many others. Ryan is currently working as a writer and financial modeling consultant on hedging and capital appreciation strategies, and does not own securities in the companies being covered.
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