St. Jude Medical Inc.: In-Line Is Just Not Good Enough

It's hard to call it a bad thing when Wall Street likes a stock, but rising expectations can create problems of their own. St. Jude Medical (NYSE: STJ  ) seems to have done a good job of selling the Street on the idea that it has turned over a new leaf and that accelerating growth is around the corner.

Sell-side price targets are about 20% higher now than at the beginning of 2014, and the buy/hold/sell recommendation breakdown has moved from 11-10-3 to 14-8-2 over the past three months, though the EPS targets for 2014 and 2015 have hardly budged. That optimism may well explain why St. Jude's "good enough" first quarter wasn't quite good enough for investors.

A respectable performance
St. Jude reported constant currency revenue growth of nearly 4% for the quarter, coming in almost spot on with the sell-side target. CRM sales rose 3%, cardio rose 2%, and neuro rose 1%, while atrial fibrillation revenue rose 10%.

Margins and profits also closely matched expectations. Gross margin improved 120bp from last year and were within 10bp of the sell-side average. Operating income fell 1% this quarter but again were almost identical to sell-side expectations as the operating margin declined 70bp.

Likely still gaining share in CRM
St. Jude's CRM business continues to perform quite well, and though Boston Scientific (NYSE: BSX  ) and Medtronic (NYSE: MDT  ) have not yet reported for this cycle, my expectation is that St. Jude will continue to have gained share. St. Jude has done surprisingly well in the high-energy segment of the market (close to one-third of the market), where its quadripolar system has led to almost 40% share in de novo CRT-D.

Medtronic and Boston Scientific aren't going to let this stand, but St. Jude has additional levers for growth even as they close the gap in quad. Nanostim (a leadless pacemaker) should be a significant product down the line and the recent FDA approvals of the Allure Quadra CRT-P, Assurity, and Endurity pacemakers should maintain some momentum in the business. Perhaps just as important, these late March approvals suggest that the FDA is satisfied with the company's progress on its warning letters.

Is the best yet to come with a-fib?
St. Jude lagged Johnson & Johnson (NYSE: JNJ  ) in a-fib this quarter, as Johnson & Johnson saw 15% growth in its Biosense business this quarter. Johnson & Johnson is already the market leader in a-fib with better than 40% share, but I don't think that St. Jude (which is in second place with nearly one-third share) lost as much ground as feared.

The real issue for St. Jude now is getting TactiCath, a product it acquired in the deal for EndoSense, on the market. St. Jude is well behind the back in ablation catheters (#4 with 14% share) and Johnson & Johnson has made the most of having the only ablation catheter on the market with a specific AF indication. Product features like the TactiCath's force-sensing capability are certainly relevant, but just having a credible catheter product could do a lot of good. In contrast, MediGuide seems to be falling short of management's once-enthusiastic projections.

New products need to hit the ground running
One of the lingering issues at St. Jude for many years has been that management can spin a good tale about how good the growth prospects can be in three years time, but when those years actually roll around the results don't measure up. At the risk of speaking for the bears, I believe that is a key to the current bearish thesis – that St. Jude's current pipeline opportunities will once again come up short on delivery.

It's certainly true that not a lot is expected of the company's Portico transcatheter heart valve. Edwards Lifesciences is already well ahead in the market and Medtronic offers a greater range of product sizes, though recent litigation between Edwards and Medtronic may keep the latter off the market in the U.S. for a few years. Renal denervation is another growth market that has lost its luster more recently with Medtronic's clinical trial failure and St. Jude hasn't really given a clear sense of their plans here moving forward.

On a more promising here-and-now note, St. Jude did also recently get FDA approval for its Protege spinal cord stimulation device. This is the first new neuro device from the company in over five years (due in part to issues with FDA warning letters) and it should help reignite a business that has been losing momentum and market share to Medtronic and Boston Scientific.

The Bottom Line
On balance I am fairly bullish about St. Jude as a company, but I still believe that the stock has gotten a little ahead of itself. Long-term revenue growth of 5% and FCF growth of nearly 11% would make this one of the best large-cap growth stories, but it still only supports a fair value in the mid-$50's with a required rate of return of 9.5%. It would also take an EV/revenue multiple of four times to get an interesting target on the shares by that methodology, and I think that's a bit of a stretch given the historical averages for companies of this size. All told, I still like St. Jude, but not enough to earn sub-par returns on the shares.

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