FOOL ON THE HILL
Guided by Guidant

Following up on December's Industry Focus, David Forrest's best idea for the moment is Guidant, Inc. Spurred by strong sales in stents and implantable defibrillators, this cardiovascular medical device maker is showing strong growth with a weak stock price. Banzai!

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By David Forrest (TMF Bogey)
July 26, 2002

I don't know about you, but I'm only capable of one good investment idea at a time. Sure, a lot of things look interesting, and many situations probably warrant further investigation, but the truth is that I only have the energy to truly research and get comfortable with one company at a time. My best idea right now is the same one I've had since last September: Guidant Corp. (NYSE: GDT).

Guidant is a major player in the cardiovascular device market. The company makes pacemakers, implantable cardioverter defibrillators (ICD), and stents (to help re-inflate collapsed arteries). Guidant makes a bunch of other devices, but these are the largest contributors to its sales. The company also was recently approved to sell a combo device called Contak CD, which combines an ICD with some gizmos and doohickeys that help synchronize your heart's valves. Try not to let my mastery over the technical jargon fluster you.

The big deal with these heart thingamabobs is that they save lives, and most of us would be willing to pay just about anything to keep that option open, right? Heart disease is the number one killer in America. It's so nasty, in fact, that it takes more lives than the next six causes of death combined. That includes cancer, AIDS, "accidents," and other Darwinian developments. As an investor, these numbers should make you pay attention to cardiovascular device makers.

In December's Industry Focus, I wrote the following as an addendum to my report on Guidant:

By most measures, Guidant isn't cheap right now. I'm hoping that the price will drop back down and we can all buy it a little more inexpensively. We'd really love to see Guidant slip back into the $30s and wouldn't be surprised at all to see that happen.

Fortunately for me, the stock slipped into the high $20s. I'll disclose to everyone reading that I bought Guidant for the first time a few weeks ago at a little over $29. Aside from the market's dive since December, one large cloud hangs over Guidant's head. You see, Guidant is in a race with Johnson & Johnson (NYSE: JNJ) and a few other companies to deliver to market a "drug-eluting stent." Ordinary stents are kind of like little steel mesh umbrellas. When you have a collapsed artery, the doctor slides one of these little babies into your artery, opens it to prop the artery up, and keeps it open so that blood can flow through the artery properly.

The problem is that regular steel mesh stents don't always get the job done. Arteries will often collapse again after a period of time, for any number of reasons. This is called restenosis.

What Guidant, Johnson & Johnson, and other companies have figured out is that you can coat the ordinary stent with a drug that will help keep the artery open and lower restenosis rates. This is fantastic news for everyone, and there's a mad dash to go to market first. By all accounts, Johnson & Johnson is winning this race by about six months. Guidant has teamed up with a private company named Cook Corp. to develop these drug-eluting stents.

Everything was hunky-dory until Cook was sued by Boston Scientific (NYSE: BSX) for licensing this special drug-eluting stent technology to Guidant. Apparently Boston Scientific and Cook have a co-exclusive licensing agreement for this technology with another (sheesh!) company, Angiotech Pharmaceuticals, and weren't allowed to share it. So, when Cook shared with Guidant, Boston Scientific sued Cook.

Rather than turn this into a bad episode of Days of Our Lives, just understand that the judge ruled in favor of Boston Scientific. In other words, the judge agrees with Boston Scientific that Cook shouldn't have shared the technology with Guidant. Unfortunately, when it comes to trying to get a drug-eluting stent to market, this is potentially bad news for investors. This is one major reason Guidant's stock has taken a beating.

I spoke with the good people at Guidant and asked them what they intended to do about this conundrum. While they declined to comment specifically about which path they're taking, one fellow helped me to frame up the possible solutions to the problem:

  1. Let the legal process continue with appeals and hope to win.

  2. Set up some business structure with Cook that would allow them to work together and not violate the licensing agreement.

  3. Acquire Cook (or Boston Scientific), which would transfer rights to Guidant.

  4. Settle this with Boston Scientific in such a way as to allow Cook and Guidant to proceed.

I don't really know which way they plan to go. And, to be perfectly honest, I don't really have a preference, other than to say I want them to spend as little as possible to get access to this technology. What I do care about, and what makes me feel pretty good as an investor, is that they have four very reasonable possibilities outlined.

In the quarterly conference call last Friday, the CEO said he's working on this situation daily, and that he doesn't think it'll be too long before the company brings some sort of resolution to fruition. In other words, they are going to solve this problem and proceed with drug-eluting stents. The real question is, how much will Guidant have to pay to get there? The long and short of it is that I don't really consider this cloud to be problematic, though I reserve the right to change my mind if the company pays some obscene amount to remedy things.

Speaking of the earnings report, the second reason I like Guidant is its numbers. They look fantastic. Last week, it reported earnings and revenue growth that exceeded previous guidance. The executive team was genuinely surprised at the robustness of the company's business, not in a doe-eyed way, but in a way that makes you feel good about future prospects. Guidant raised earnings-per-share (EPS) guidance for the year to between $2 and $2.06.

At $31.50, the stock is trading at 15 times estimates that are only six months removed. The company projects revenue growth at 19%-25% for the third quarter and EPS growth of 25%-33%. Guidant did not release a cash flow statement with its earnings report last week (something all companies should do), but using the prior four quarters' numbers, the company trades at 18 times free cash flow and 13 times operating cash flow.

With drug-eluting stents on the horizon and company guidance of 25% EPS growth, I'm projecting $3.20-$3.50 for fiscal 2004. My guess is that the stock can carry a 20 multiple on those earnings and trade between $64 and $70 within two years. If I'm right, that's an annualized return of 43% on the low side and 50% on the high side.

With recent company news offering a fundamental cushion for the stock and some sort of resolution of the drug-eluting stent issue on the horizon, I'm pretty comfortable with the risk-reward scenario.

From where I stand, Guidant looks like a keeper.

David Forrest loves Twinkies, ice cream, and chicken burritos. He's happy to be a shareholder in a company (Guidant) whose products will likely save his sorry butt one day. The Motley Fool has a disclosure policy.