St. Jude Medical, Inc. Still Feeling the Love

I thought St. Jude Medical (NYSE: STJ  ) was already getting a fair bit of the benefit of the doubt back in April, but Wall Street has continued to bid these shares up on growing hopes that new products from the pipeline will drive revenue growth back into the mid-single digits or higher. Up almost 10% over the last three months, St. Jude has modestly outperformed Medtronic (NYSE: MDT  ) , significantly outperformed Boston Scientific (NYSE: BSX  ) , and done rather well against Johnson & Johnson and the market as a whole.

My basic outlook on St. Jude really hasn't changed much. I think many in the market overestimate the likelihood that the company will lose significant share in quadripolar systems and underestimate the potential for products like Portico (a transcatheter heart valve) and CardioMEMS (an implantable monitoring device for heart failure) to contribute meaningfully to results. All of that said, the market appears to be baking in low-to-mid teens annual cash flow growth over the next decade and that seems like a sufficiently bullish outlook.

A better result this time around
St. Jude management had said on more than one occasion that they believed their guidance for the second quarter was conservative, and I guess they came through. Revenue rose 3% in constant currency, beating expectations slightly (by less than 1%) and EPS likewise were slightly ahead of expectations ($1.02 versus $1.00).

St. Jude's CRM business contributes about half of the company's sales, and revenue rose 2% here. Pacing product sales rose almost 3%, while ICD sales grew just less than 2%. While the OUS ICD sales were not superb (up 1% in constant currency), more than a few analysts have been predicting doom and gloom in the form of significant share gains favoring Medtronic and Boston Scientific. St. Jude continues to hold its own, though, helped in part by innovations like multipoint pacing and the clinical superiority of its quadripolar leads (Medtronic's show a higher incidence of phrenic nerve stimulation).

Cardiovascular sales were up 3% and neuromodulation sales were down 1%. The cardiovascular business continues to languish as Medtronic and Edwards Lifescience grab share from traditional heart valves with their transcatheter products and St. Jude's own products like the Portico transcatheter valve and Amplazter closure device have yet to emerge as real contributors (neither are approved in the U.S.).

With Johnson & Johnson reported 14% yoy growth in a-fib, St. Jude's 8% growth has to be seen as at least a little disappointing. St. Jude's best chance of gaining share in the fast-growing $1 billion catheter-based market is its new TactiCath product, due out in the U.S. later this year.

In terms of other operating items, St. Jude didn't do great on the gross margin line, with margin falling a full point and slightly below expectation. Slightly lower than expected SG&A and R&D spending helped, though, and the company's operating profits rose 2%. Of the two-cent beat, St. Jude got a penny through lower operating costs and the other penny from a lower share count.

CRM competition isn't going to fade, but neither is St. Jude
Reports of the imminent demise of St. Jude's CRM business continue to be exaggerated, as the company stubbornly withstands competition from Boston Scientific and Medtronic. On the Boston Scientific side, I am starting to wonder if the S-ICD product is having a bigger impact on the company itself (cannibalizing single-chamber product sales) than St. Jude or Medtronic. As far as Medtronic goes, I wouldn't underestimate this company in quadripolar, but St. Jude's leads may be a competitive advantage as they induce less phrenic nerve stimulation (though at 2%, it's not as if Medtronic's leads are tremendously problematic).

As far as new products go, we'll wait and see. St. Jude's U.S. trial for multipoint pacing should finish this year; multipoint pacing gives physicians more options in customizing therapy for each patient. St. Jude did worry investors with word that the European study of Nanostim saw six perforations, but these issues may well have been due to improper enrollment and/or physician inexperience with the device.

Can St. Jude win with depth in a breadth world?
When Medtronic bid for Covidien, it was in part about covering a larger part of the waterfront in med-tech and offering a comprehensive set of tools, technologies, and interventions. St. Jude believes that it does need to try to match Medtronic or Boston Scientific in the breadth of therapeutic areas they address. Instead, St. Jude believes it can win by having deep specialization in areas like CRM, electrophysiology, and neuromodulation.

Time will tell, but I wouldn't be shocked to see St. Jude's name enter the M&A rumor mill. Johnson & Johnson has said that it does not want to enter low-growth markets like CRM (it voluntarily abandoned cardiac stents), but Abbott could conceivably look at St. Jude as a way to gain considerable scale in cardiology. I think St. Jude would be a much larger deal than Abbott would prefer, but stranger things have happened.

The bottom line
Given the valuation on the shares, St. Jude management pretty much has to execute on new product opportunities like CardioMEMS, Portico, TactiCath, and so on or the shares are likely to languish. Although I am bullish on the company, I think the stock already reflects enough bullishness and I'm not all that tempted by today's price.

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