The Heartbeat of a Competitor

10/07/2010 12:00 pm EST

Focus: STOCKS

Paul Larson

Editor, Morningstar StockInvestor

Paul Larson, equities strategist and editor of Morningstar StockInvestor, and analyst Debbie S. Wang like a medical device maker that has stayed competitive through innovation.

St. Jude Medical (NYSE: STJ) manufactures cardiovascular medical devices, including the world’s most widely used mechanical heart valve.

Its products include tissue heart valves, pacemakers, implantable cardioverter defibrillators, and vascular closure devices for catheterization procedures. St. Jude sells its products to hospitals and heart-surgery centers in the United States and abroad. Foreign sales make up more than 45% of total sales.

While impending health care reform will likely reverberate across all the cardiac device companies, we think the firms will likely preserve the stable oligopoly that is in place. St. Jude Medical benefits from the device industry’s high barriers to entry and has done a nice job of closing the historical gap with its key rivals Medtronic (NYSE: MDT) and Boston Scientific (NYSE: BSX).

Originally known as a pioneer in mechanical heart valves, St. Jude branched out considerably with acquisitions. Diversification has been the key to the firm’s growth during the last five years, allowing it to tap into robust markets for implantable cardioverter defibrillators (ICD), while mechanical heart valve sales continue to decline. In 2008, cardiac-rhythm management devices accounted for about 74% of total sales, with heart valves contributing only 7%.

In the last few years, St. Jude has revved up its innovation and beefed up its sales force—the two lynchpins that are critical to strengthening St. Jude’s competitive advantage. No longer a distant third, St. Jude’s ICD market share runs neck and neck with Boston’s.

We expect St. Jude to offer tough competition, especially as it races to establish presence in neuromodulation (which alters nerve activity through the delivery of electrical stimulation or chemical agents to targeted sites of the body—Editor), and catheter-based ablation for atrial fibrillation (abnormal heart rhythms involving the heart’s upper chambers—Editor). [These are] the two therapeutic areas associated with substantial untreated populations, and could potentially develop into multibillion-dollar markets.

As long as St. Jude does not fall too far behind [in] innovation, it should be able to maintain its competitive advantage. Considering the difficulty of amassing the intellectual property, expertise in manufacturing in accordance with extensive regulations, and building relationships with practitioners, it is extremely unlikely that another competitor of St. Jude’s caliber would break into this market any time soon.

Our fair value estimate is $47 per share. (The stock closed below $40 Wednesday—Editor.) We expect tighter hospital budgets should damp St. Jude’s growth over the next few years. In total, we project 6.6% average annual top-line growth through 2014, fueled by atrial fibrillation and neuromodulation devices, as well as sales from new acquisitions.

Although sales and administrative costs inched up over 2008, we expect St. Jude’s cost-cutting measures in 2009 to trim operating expenses. We expect the firm [to] sustain its recent gains in gross margins thanks to shifts in product mix.

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