Saturday, October 20, 2012

BSX F3Q12 Earnings 10/18/12 - (Ryan Kennedy)

     Boston Scientific released Q3 earnings on 10/18 and subsequently traded down 7% over the next two days compared to market losses of 2%. The company reported adjusted EPS of $0.16 per share, which was in-line with analyst consensus estimates and towards the upper range of management's guidance. Despite this, the stock fell heavily due to continued weakness in the firm's revenues, which fell 5% on a constant currency basis.
     BSX reported revenues of $1.74bn compared to $1.87bn over the same period a year ago. The firm has faced significant headwinds in its two main divisions, the Cardiac Rhythm Management and International Cardiology units, which account for 55% of BSX's total revenues. The Interventional Cardiology unit, which produces coronary stents, reported a 20% decline in sales driven by eroding market share from Medtronic's Resolute stent system. Goldman Sachs' analyst, David Roman, estimates the firm lost 5.2% market share YOY in the drug-eluting stent (DES) market primarily due to the Resolute Integrity. Management now estimates the company has mid- to high-30s in DES market share. Going forward, management expects to recapture market share due to the Promus Element, however, we expect the DES market to remain highly competitive with Abbott Laboratories, Medtronic, and Boston Scientific continuing to one-up each other.
     BSX also has faced difficulties in the Cardiac Rhythym Management (CRM) unit. Revenues in the CRM unit declined 8% driven by weaknesses in the broader CRM market. The use of implantable cardioverter defibrillators (ICDs) has declined since a research paper in the Journal of the American Medical Association suggested that 23% of ICD implantation were not evidence based, and the procedure should not have taken place. The research paper sparked a Department of Justice investigation into ICD implants, which has made physicians reluctant to perform the procedure without overwhelming evidence. Despite this, current research by UCLA Medical Center found that there are over 850,000 heart failure patients in the US who are eligible for an ICD but have not received one, countering the claim of overuse and suggesting potential growth in the area. Out of the firm's two main segments, CRM is the one with the highest potential for growth. Despite a weakening market, BSX has managed to increase market share with its Ingenio platform. Additionally, BSX has the first subcutaneous S-ICD, which has received early FDA approval, through the acquisition of Cameron Health. The S-ICD has the potential to be a blockbuster product for BSX, as it is the first device of its kind that doesn't require the attachment of electrical wires to the heart, and eliminates serious risks associated with previous devices. Lastly, a recent research paper has suggest the CRM has the potential to become a $12.5bn market by 2017 due to international growth (BSX's CRM sales are currently $462mm), and BSX plants to spend $150mm over the next 5 years to expand into the untapped Chinese market.
     Aside from the two main units, BSX saw above-market growth in 7 of 12 business units. Endoscopy and Peripheral Interventions both grew 7% on a constant currency basis, and are the firm's third and fourth largest units. These two units now account for 29% of the firm's revenues, and continue to post mid to high-single digit growth YOY. As these segments continue to growth, less emphasis will be placed on growth in the CRM and IC units.
     Despite disappointing sales, BSX has made tremendous strides in profitability. Gross margins expanded 400 bps, from 64% to 68%, as the product mix has shifted from the Promus stent to the Promus Element stent system, which carries significantly higher margins. This trend, however, is not expected to continue into the near future as the shift to the Element is nearly complete.
     Overall, Boston Scientific has continued to meet expectations on bottom-line growth and generate strong operating cash flows. Despite this, the stock has continued to trade off top-line growth, particularly within the CRM and IC units. Given the strides in profitability, any signs of strength in the franchise segments will warrant significantly higher valuation for the company. Given the prospects of the S-ICD, international growth in the CRM unit, and continued growth in the PI and Endoscopy units, we believe BSX may finally be on track for positive revenue growth. Management believes the stock is undervalued and is committed to using 50% of cash for share buybacks, which should create shareholder value going forward. BSX currently trades at a discount to peers in P/E, P/S, P/BV, EV/FCF, EV/EBITDA, and PEG, and we do not believe this is an opportune time to exit the stock. In conclusion, we reiterate a BUY rating for Boston Scientific Corporation.

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