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Wall Street can punish stocks quickly, but investors will return to a solid story almost as quickly. It was only about a year ago when St. Jude Medical (NYSE: STJ ) shares were hammered on worries that lead failures would severely compromise the company's ICD business and that the company was trailing major rivals like Medtronic (NYSE: MDT ) and Johnson & Johnson (NYSE: JNJ ) in key growth market opportunities.
Since then, sentiment has come back around in a big way. Not only does the company appear to be gaining some share in its cardiac rhythm management, or CRM, business, but the atrial fibrillation business has also been performing well. Add to that interesting opportunities in heart failure monitoring, neurostim, ablation, renal denervation, transcatheter heart valves, and a leadless pacer, and I think St. Jude has enjoyed a well-deserved recovery.
Some bad, but mostly good in the third quarter
St. Jude's third quarter wasn't flawless, but it wasn't bad, either -- just the sort of quarter to annoy bears and keep the bulls generally positive on the stock. Revenue rose just 1% (or 3% on a constant currency basis), but that was good for a small beat.
Revenue growth was once again led by the atrial fibrillation business, where St. Jude's 10% constant currency growth kept pace with Johnson & Johnson's 11% growth. CRM was flat, but the 2% growth in the ICD business suggests that St. Jude is taking share in the U.S. (most likely at the expense of Boston Scientific and not Medtronic). Neuro was a little sluggish (up 3%) due to the constraints of a warning letter, though the ex-U.S. business was stronger. Last and not least, St. Jude's cardiology business saw 4% growth.
The big "but" for the quarter was at the gross margin line. Gross margin fell more than two points from last year and missed the average Wall Street guess by about 70 basis points. Management's explanation on the call seemed reasonable -- a greater impact from foreign exchange and a higher mix of devices subject to the medical device sales tax combined to bring in a lower-than-expected number. Even so, the 5% reported decline in operating income isn't particularly compelling.
Multiple shots on goal to improve results
I wouldn't say that St. Jude got itself into bad shape, but the fact is that its core CRM and legacy heart valve businesses have slowed significantly and aren't likely to be major growth drivers in the future. That led analysts to ratchet down their expectations, targets, and ratings for the stock. I do believe, though, that the company has acquired a variety of promising technologies and products that should lift long-term revenue growth back into the mid-single digits.
Medtronic beat the field with the first MRI-safe pacemaker, and Boston Scientific's subcutaneous ICD (acquired in its deal for Cameron Health) has significant long-term potential. Couple those two advances with St. Jude's energy leads problems, and I understand why investors were down on the CRM business. Even so, I think investors shouldn't underestimate the potential of the Nanostim leadless pacer – a device that could be multiple years ahead of Medtronic.
I'm also more bullish than average on St. Jude's transcatheter heart valve business. The prevailing wisdom is that Edwards Lifesciences and Medtronic will have the market locked up before St. Jude is even in the running, but I think St. Jude's cuff design and the ability to resheath and reposition the valve will be solid enough factors to at least allow mid-teens market share.
CardioMems is another interesting opportunity for St. Jude. CardioMems has developed an implanted sensor that measures pulmonary artery pressure and allows doctors to adjust the treatment protocols for congestive heart failure patients, improving their health and reducing the number of hospitalizations. This isn't a slam-dunk marketing success (the FDA panel voted 6-4 that the benefits outweighed the risks, but also only 4-7 that there was "reasonable assurance" of efficacy). St. Jude has the option to acquire CardioMems, and the device could address a nearly $2 billion revenue opportunity at full penetration.
The bottom line
I've been a St. Jude bull for a while, but the valuation is harder and harder to justify. While I do believe you can argue for a fair value of $55 if everything goes well (based on revenue and cash flow growth in the 6% to 7% range), my base-case scenario is closer to $50 right now. I wouldn't be in a hurry to sell if I owned shares (though I might think about protective stops), but it's hard for me to argue as strongly for buying St. Jude now that sentiment has shifted more firmly into bullish territory.
Medical devices don't come cheap
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