The following analysis is a valuation of St. Jude Medical (
) using an economic profit model, a primer on which can be found
To begin, the company's operating segments are detailed while
also analyzing recent operating performance.
Next, the company's adjusted financial accounts and market
capitalization are presented leading to a reference valuation
scenario. A number of alternate scenarios are considered given
variations in assumptions about growth, returns on capital and
After integrating a forward looking view of the company's
position, an investment conclusion is formed.
Corporate Description and Operating Performance
St. Jude operates in four business segments, which the company
combines into two for reporting operating income as shown in the
click on image to enlarge
Cardiac rhythm management ((
)) is St Jude's largest operating segment and the most mature piece
of the portfolio. Products include implantable cardioverter
defibrillators (ICDs) and pacemakers. Overall market growth in
terms of volume is mid-single digits, while prices are falling high
single digits leading to a slightly declining market. St. Jude
reports that it is taking a small amount of share currently.
Grouped with CRM is the neuromodulation business due to the
similarity of the technology. These devices send electrical signals
to control pain in spinal and other injuries. A number of other
proposed uses for the devices are undergoing trials and the
underlying growth rate is high single digits.
The cardiovascular segment has grown through a number of
acquisitions in recent years including the acquisition of AGA
Medical in late 2010. The segment contains a large number of
products such as vascular closure devices, heart valves and
pressure management guidewires. The company is also developing
imaging technology to analyze the heart and vascular system more
effectively which is an area of future growth. The segment
currently is showing strong results for St. Jude with over 20%
Similarly, the atrial fibrillation business is also growing
strongly for St. Jude at over 15%, with the company taking several
points of share. Products include electrophysiology introducers and
catheters, navigation and recording systems and ablation systems.
The segment is primarily geared toward selling products to perform
ablation procedures which treat heart arrhythmia. Looking at the
company's segments in whole, investors would be safe in tagging St.
Jude as the "The Heart Company".
The following table lays out gross income assumptions for the
reference valuation scenario:
Net income of $1,066 million works out to $3.24 per basic share
excluding interest income. The reference period is the twelve
months starting Q2 2011 through Q1 2012and relies on management
guidance for Q# 2011 and analyst estimates minus a couple cents for
Q4 2011 and Q4 2012. The small deduction from analyst estimates is
to control for asset additions - the object at this stage is to
calculate what the company makes on its current asset base.
Two adjustments have been made to net income which are broken
out separately at the bottom of the table. First is the impact of
H.R. 4872 [111th]: Health Care and Education Reconciliation Act of
2010's 2.3% medical device excise tax coming into effect in 2013. A
$25 million per year after income tax impact has been modeled based
on the company's U.S. based revenue and an incidence of tax of 50%
which contemplates that the company may be able to raise prices
marginally in the wake of the excise tax.
In addition, it is likely that at least a portion of St. Jude's
U.S. sales are not subject to the excise tax which serves as a
buffer to the estimate. The second adjustment is a normalized
restructuring expense of $35 million per year. St. Jude has a long
history of such expenses and they should be considered a normal
part of its operations.
The remaining elements of gross income are straightforward
consisting of the cash flows which support various assets and
liabilities including current R&D expense, depreciation and
amortization and interest expense.
As the table below highlights, the company's largest portion of
invested capital is in technology development which includes
R&D and the majority of purchased intangibles:
The most meaningful adjustments compared to the company's
reported accounts are in the capitalization of R&D and
marketing, which also impacts purchased intangibles because some of
those expenses are used to recapitalize the purchased intangibles
account in the model.
The table below shows the current market capitalization of the
company, with the equity trading at $41.96:
Non-traded obligations (pensions, tax, etc.) are a relatively
small piece of firm value and very few adjustments have been made.
The company does have some $400 million of other unidentified
long-term liabilities. The model estimates half of these are
obligations worth considering in firm value and they show up in
other liabilities in the table along with warranty accruals.
Valuation and Scenario Analysis
The following table details the internal rate of return ((
)) calculation used to determine the company's returns on
The company's IRR is 20.1% with a reinvestment rate of 13.6%
which assumes about half the company's gross cash flow can be
reinvested at the IRR. That leads to a modified IRR ((MIRR)) of
16.1%. A 20% IRR is relatively high compared to the cost of capital
and over the long-term it would be expected that returns would fade
somewhat. This is a company where internal investment performance
must be monitored closely.
The following table summarizes a number of scenarios with
further explanation following:
Due to large increases in investment over the past several years,
particularly in R&D, the company's reference valuation is
reliant on some amount of growth in income. For returns on capital
to remain stable, and hence the valuation to remain the same,
income will need to grow by about $50 million per year for at least
the next few years based on increasing capital invested in R&D
alone. Adding increased investment in other parts of the business,
the growth expectations are likely higher by another $10-20
million. If this growth does not materialize, it's likely that St.
Jude would pare back R&D and other spending and therefore the
valuation impact could be lessened.
If the company can grow in excess of the embedded growth
assumptions described in the reference case, the shares will
warrant a higher fair value as shown in the table above.
Sharp Decline in R&D Productivity
With the embedded growth expectation in the valuation of the stock
highlighted in the reference case, it is worth looking at a
hypothetical valuation where income does not increase to support
all the recent investment. It is very unlikely that no additional
income will be created and that should additional income not
materialize that the company will not make adjustments to its cost
structure; however, it is useful to detail the hypothetical
nonetheless. The value in the table above assumes the company adds
$1.5 billion of gross capital with no increase of income. This
should be viewed as more than a worst case scenario for declining
returns on capital, but does highlight the importance of growth for
Product Liability Contingency
To be clear from the outset, there is no indication that St. Jude
has any current product liability issues. However, the lesson of
Boston Scientific (
) is that the medical device business has litigation risk and
ignoring it in valuation won't make it go away. Given a potential
cost of $2.5 billion and a probability of 20% over the company's
asset life, a hypothetical $500 million current liability is
applied to the company implying a slight reduction of value as
shown in the scenario table above.
Repeal of Medical Device Excess Tax
Given today's large budget deficits and the recent downgrade of the
U.S. sovereign debt rating, it looks increasingly unlikely that the
medical device makers will gain relief from new taxes scheduled to
begin in 2013. However, in the event of repeal, the company will be
able to avoid at least $25 million of new taxes and should enjoy a
slightly higher equity valuation as shown in the table above.
Market Implied Economic Profits
With the stock trading under fair value it's useful to look at what
the market may be implying about the future of St. Jude. Typically,
in a case of undervaluation either the market expects income to
fall or investment to rise without a compensating increase in
income. It is more likely in this case that the market is
discounting a fall in returns on capital due to increased
investment leading to a reduction of about one percentage point in
the MIRR from 16.6% to 15.5%.
The following table shows the value of equity at various net income
levels (excluding net income adjustments):
Given the scenarios laid out, I am comfortable with the stock
right around the reference valuation level. This leaves some upside
for additional growth while realizing that the company has some
hurdles in front of it in terms of realizing returns on recent
investments with some of the company's markets showing very slow or
even slightly negative growth. It also leaves some room for error
in the case of a mishap on the product liability front.
I am constructive on the markets the company operates in due to
the aging of the population and the ability to apply technology to
increase lifespan. I think the developed world population puts a
high priority on quality and quantity of life and will petition
governments through the ballot box to continue to support medical
spending as well as spending their own dollars. In addition, the
developing markets will increasingly be able to pay for advanced
I would not consider St. Jude's stock cheap although it is
trading at about a 5% discount to fair value. No valuation process
can be precise enough to peg value within 5%. However, I do believe
St. Jude is fairly valued which implies it should provide
equity-like returns in the future.
I am long
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