All told, Boston Scientific (BSX -0.25%) did alright in the second quarter, but the inter-segment noise highlights one of the ongoing challenges for the company – keeping all the ducks in a row and delivering both top-line growth and margin improvement. I'm still skeptical that these shares really make sense from a long-term cash flow perspective, but I cannot argue that the company has not made progress and could generate significant earnings growth in the coming years.
An OK Q2, but mind the moving parts
All told, this wasn't a bad quarter for Boston Scientific, but it's also not one that leads me to get more excited about the shares. A lot of the top-line outperformance came from markets with below-average long-term growth prospects and the margin performance still has a lot of room for improvement.
Revenue rose just under 3% on an organic basis and eked out a small beat versus Street expectations. What was unusual was that CRM and stents led the outperformance. Cardiovascular revenue rose 2%, with 3% growth in peripheral vascular and 1% growth in interventional cardiology, but 4% growth in drug-eluting stents – good for 5% beat. Based at least in part on the performance of the new Promus Premier, Boston Scientific grabbed share from Abbott Labs this quarter (where drug-coated stent sales fell 5%).
CRM revenue rose 4%, beating expectations by 4%, as Boston Scientific saw the best results it has seen in about five years with ICD sales up 3% and pacemaker sales up 6%. ICDs were led by good demand for the company's new quad generators and S-ICDs and Boston Scientific saw more than double the rate of growth in U.S. ICD sales than St. Jude Medical at 4.5% versus 1.9%. Medtronic has yet to report, but unless Medtronic really comes in with a strong result, it looks like it will be the "share donor" this quarter.
The bad news about the quarter is that the other businesses were not as strong on a relative basis. Urology was up 7% and Electrophysiology was up 56%, both fine vis a vis expectations, but Endoscopy was up 4% and Nueromodulation was up 3% and both came in light.
Gross margin declined about a half-point and was about a quarter-point weaker than expected. Operating income rose 4% (including amortization) and operating margin improved just slightly. Earnings quality wasn't so great, though, as the company benefited from lower royalty expense and, below the operating line, a lower tax rate.
Can Boston Scientific keep its growth ambitions intact?
Of the big three CRM companies, Medtronic, St. Jude, and Boston Scientific have all seen their bullish pipeline-driven growth expectations lose some luster. Medtronic has seen the failure of its renal denervation program and disappointing results in drug-coated balloons for peripheral intervention, and also saw itself forced to the bargaining table with Edwards Lifesciences in litigation over transcatheter heart values. St. Jude has also been reconsidering its renal denervation strategy and rethinking its approach to its left atrial appendage closure trials, not to mention struggling to get its neuromodulation business back on track.
Boston Scientific has some of the same challenges in renal denervation, but management has sounded more bullish here. The company was also dealt another setback in its attempts to get the Watchman LAA device on the market when the FDA called for a third panel meeting (the prior two were both favorable for the company). Drumming up interest in the Alair thermoplasty product continues to prove difficult and analysts remain skeptical about the prospects for what should be the third or fourth transcatheter heart value in the U.S. market (BSX's Lotus valve).
On the positive side, I do believe that the Watchman could be a $500 million device, but the FDA is not making it easy (not so surprising for a first-in-class device). I also think the market may be overstating the long-term time-to-market advantages enjoyed by Medtronic and Edwards in heart valves. I'd also note that the company has stepped up its game in peripheral intervention.
All told, I'm cautiously optimistic here. I don't expect sustainable growth in the CRM business; Medtronic and Boston Scientific may gain some ground on St. Jude in quad, but overall I see this as shuffling deck chairs on a boat destined to sail slowly. Likewise in stents; Boston Scientific may have an edge now on Abbott, but the game of product leapfrog between Abbott, Medtronic, and Boston Scientific amid low single-digit market growth isn't going to build strong long-term value.
I'm also a little concerned about Boston Scientific's tax situation. Like most other medical companies with substantial overseas businesses, BSX uses transfer pricing to try to shift profits toward lower-tax jurisdictions. While this is legal (to a point), the IRS is taking a closer look at these practices and the end result could be higher effective tax rates in the future.
The bottom line
There is still some potential upside when valuing on the basis of EV/revenue – Boston Scientific trades below 3x its forward revenue estimates, while Medtronic and St. Jude trade closer to 3.5x. You can certainly argue that Boston Scientific's lower margins and returns merit a lower multiple, but the higher expected growth rate is an offsetting factor in the company's favor. Net net, Boston Scientific is what it has long been – a controversial and divisive company with the potential to do considerably better than it has, but enough operating slip-ups to raise the question of whether it ever will.
