The Medical Device Pacesetter

11/07/2012 7:45 am EST

Focus: STOCKS

This company has been around for a long time, and has built business niches that are almost unassailable...and wide moats and good management make a great stock, writes Debbie S. Wang of Morningstar StockInvestor.

St. Jude Medical (STJ) benefits from the device industry’s high barriers to entry, and has done a nice job of closing the historical gap with key rivals Medtronic (MDT) and Boston Scientific (BSX). St. Jude even has taken the lead in certain therapeutic areas, which underscores the wide moat that the firm enjoys.

Originally known as a pioneer in mechanical heart valves, St. Jude branched out considerably with various acquisitions. Diversification has been the key to the firm’s growth during the past ten years, allowing it to tap into robust markets for implantable cardioverter defibrillators (ICDs) while mechanical heart valve sales continue to decline. In 2011, cardiac rhythm management devices accounted for about 54% of total sales, with heart valves contributing an estimated 7%.

With the implantable cardioverter defibrillator market shrinking in the low single digits last year, St. Jude has an opportunity to press its advantage and grab market share with a steady stream of new products, including the first quadripolar lead ICD. During the past five years, St. Jude has revved up its innovation and beefed up its sales force—the two linchpins that are critical to strengthening its competitive advantage.

St. Jude has closed the lag period where it previously trailed Boston Scientific’s and Medtronic’s next-generation products by a few years. Now, the firm is competing head-to-head and rolling out the latest technology as its competitors do the same. No longer a distant third, St. Jude’s ICD market share has been edging out Boston’s during the past four years.

We’re also excited about St. Jude’s foray into three therapeutic areas that hold potential for growth. First, the purchase of Advanced Neuromodulation Systems in 2005 puts St. Jude squarely in the fast-growing neuromodulation market.

Although the market for spinal cord stimulators primarily has focused on addressing patients with chronic pain, the technology also has therapeutic potential for other conditions such as treatment-resistant depression, epilepsy, incontinence, and Parkinson’s disease. During the next five years, we anticipate more neuromodulation devices will be approved for some of these applications.

In Europe, St. Jude already is rolling out its device to address Parkinson’s, and we expect the launch of another device for migraines in 2012. The company also has forged ahead with the development of catheter-based ablation devices to treat atrial fibrillation, a condition that affects more than 2 million Americans and for which there are few effective drug therapies.

Finally, St. Jude’s equity investment in privately held CardioMems holds considerable potential in this new age of health care, where providers have financial incentives to keep patients from returning to the hospital after an episode of care.

The CardioMems implantable wireless diagnostic helps monitor heart failure patients—a population prone to rehospitalization—and gives practitioners enough early warning to intervene in the event the patient’s heart failure symptoms worsen, which lowers the chances of that patient landing in the hospital again.

Even though an FDA panel concluded that St. Jude had not demonstrated that the benefits of the device outweighed the risks, we expect the firm will either reanalyze the clinical data, or potentially undertake a better-designed clinical trial to continue development. Savvy investment in development of these types of products has fueled double-digit sales growth during the past eight years, and operating margins have improved by about 720 basis points since 2001 (excluding special charges).

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Management has taken solid steps to strengthen St. Jude, and the company is giving its peers a run for their money. We expect St. Jude to offer tough competition, especially as it races to solidify its presence in neuromodulation, renal ablation, and catheter-based ablation for atrial fibrillation—the three therapeutic areas that are associated with substantial untreated populations and could develop into multibillion-dollar markets.

While we expect the domestic launch of St. Jude’s next-generation Unify Quadra CRT-D product to result in market-share gains, we recognize that unanswered questions about how to more accurately identify patients who will benefit from defibrillation leave the US market in an anemic state.

As a result, we have projected low-single-digit sales growth for ICDs in 2012, but we wind that down by 100 basis points in 2013. Even though rival Medtronic eked out some pacemaker share gains in 2011 thanks to its MRI-compatible product, we expect St. Jude should regain some of that share loss once it launches its comparable Accent pacemaker in 2012.

Overall, we expect strength in atrial fibrillation, structural heart, vascular, and neuromodulation devices to fuel mid-single-digit revenue growth during the next five years.

Going forward, we expect sales and marketing expenses will remain somewhat elevated in the near term in order to support and successfully commercialize several new technology platforms currently in development. In the longer term, we anticipate a slight rise in research-and-development spending, as the FDA is likely to require more post-marketing studies in the future.

Thanks to the cost benefits of shifting manufacturing to new facilities in Costa Rica and Malaysia, we project an incremental 80-basis-point gain in operating margins by 2016 after accounting for the 2% cut in Medicare reimbursement, leading to 8% net income growth.

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