This Company Is a Value Stock! Isn't It?

As the pharmaceutical and biotech online editor here at the Fool, I read all kinds of opinions about companies in the sector, especially those thought to be values. One I read last night caused me to raise my eyebrows so high that my toupee threatened to slip off. (I actually still have my hair, but it's a great image.)

In his Monday column for Bloomberg, John Dorfman of Thunderstorm Capital presented four companies that he felt might be picked by Benjamin Graham, the father of value investing. Dorfman was looking for companies trading below book value, trading below 12 times earnings, and having debt less than 50% of equity.

The companies he chose were civil and building construction firm Tutor Perini, drilling company Rowan (NYSE:RDC), outdoor gear retailer Cabela's (NYSE:CAB), and -- this is where my interest comes in -- medical device provider Boston Scientific (NYSE:BSX).

Three reasons he picked Boston Scientific were:

• Trading at 0.9 times book.
• Trading at 10 times earnings.
• It had increased revenue to $8 billion from 2004's $5.6 billion.

Regarding the other three companies, I have no opinion whatsoever, not being an expert on them. But I do disagree with his choice of Boston Scientific.

On the surface, yes ...
Yes, it is trading below book value. However, if you back out its $12.4 billion in goodwill and $6.8 billion of intangible assets, both mostly due to its 2006 acquisition of Guidant, Boston Scientific has a negative tangible book value of about $5.7 billion.

The goodwill asset is not solid, and it can be reasonably argued that Boston Scientific overpaid when it beat out Johnson & Johnson (NYSE:JNJ) to purchase Guidant. At the end of last year, Boston Scientific had to recognize that when it wrote down nearly $2.6 billion worth of goodwill from the Guidant acquisition. Companies are loath to make such a move.

What P/E?
On a trailing basis, the company doesn't have a P/E ratio, thanks to that goodwill writedown. However, if you take management's guidance for 2009 GAAP earnings per share of $0.43 to $0.48, the company closed last night with a P/E of roughly 17 to 19 for 2009 earnings. That's quite a bit above the upper limit of 12 that Dorfman laid out and the P/E of 10 he claimed for Boston Scientific.

But you can get there. Instead of GAAP, which includes such pesky items as amortization and restructuring charges, take the best of management's guidance for non-GAAP EPS for 2009. That gets you to 10.6 using last night's closing price. And there you are.

Except ... backing out charges like amortization (which the company has done to its intangible assets every year this decade) and restructuring charges (which it's done for two of the three years since acquiring Guidant) kind of misses the point of the costs of running a business that net income is supposed to represent.

Revenue is supposed to turn into cash
Finally, that revenue increase Dorfman calls out. It's supposed to be turned into cash, isn't it? In Boston Scientific's case, it hasn't. Cash flow from operations (CFFO), which backs out noncash charges such as amortization, shows how much cash is actually flowing into a business from revenue. Here's what's happened at Boston Scientific over the years mentioned:

Sources: Capital IQ (a division of Standard & Poor's) and most recent company 10-Q filings.
TTM = trailing 12 months.

See that? Only in 2006 was CFFO higher than 2004's level, and not once since 2004 has CFFO been as large a percentage of revenue. In other words, today, the company is turning just 15 cents of every dollar of revenue into cold, hard cash, whereas some five years ago, it was doing twice as well.

So what, hot shot?
The main reason Boston Scientific is not worth my investment dollars today is because of the Guidant acquisition, which happened in early 2006. I've written about this before, and today, more than three years later, there are still problems pulling management's attention away from running an efficient shop. Boston Scientific seems to have fallen prey to the problem that Michael Mauboussin, Legg Mason Capital Management's chief investment strategist, described during a visit to Motley Fool headquarters today. Two-thirds of all merger and acquisition deals end up destroying value for the acquirer, yet most managers believe that their deal will create value.

Boston Scientific might qualify as a cigar-butt investment today, but I'd be hard-pressed to call it a Graham-like value investment.

Instead, I'd rather invest in one or two other companies in the medical device area. These, for instance.

Source: Capital IQ (a division of Standard & Poor's).

While not necessarily qualifying on a Graham basis, on the surface at least, these three look better to me than does Boston Scientific. At least right now.