Boston Scientific Has A Long Road Back

By Stephen D. Simpson, CFA | October 21, 2010 AAA

Turnarounds are hard enough in the best of times, and when a company's core markets are in shaky condition it becomes all the more difficult. Even if med-tech player Boston Scientific (NYSE:BSX) is really into improving its operations, there are some significant headwinds pushing against it. Still, with a patient long-term approach to improving operations it may be possible for this company to unlock some value for its long-suffering shareholder base.

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The Quarter That Was
Boston Scientific delivered a mixed third quarter announcement - the company did well vis-a-vis analyst estimates (especially on the bottom line), but the fundamental performance was not all that strong. Consolidated revenue fell 5%, as the company balanced double-digit declines in stent revenue and high single-digit declines in cardiac rhythm management with modest growth in endosurgery and neuromodulation.

Turning to profitability, the company did manage to improve adjusted gross margin by more than a full point, and adjusted earnings grew a little bit over last year's level.

The Road Ahead
Boston Scientific is still facing some serious long-term challenges to its top-line growth. The company is getting nowhere fast competing with Medtronic (NYSE:MDT) and St. Jude (NYSE:STJ) in cardiac rhythm management, and it is unclear if the company's new Promus Element stent is going to reverse share losses to Abbott (NYSE:ABT). Making matters worse, the company has under-invested in its neuromodulation and IVUS businesses, and it seems unlikely that the company can regain ground on rivals like Medtronic, St. Jude and Volcano (Nasdaq:VOLC).

Now, the more positive side of the story. The company's still relatively new CEO comes from Zimmer (NYSE:ZMH) and has a track record of driving operating improvements - something that would clearly be very helpful for Boston Scientific. Moreover, the company seems to be willing to think aggressively about repositioning its business for the future - there are rumors that BSX might sell its neuromodulation business to Stryker (NYSE:SYK) and that other units could be on the block as well.

In Need of Differentiation
In the short run, those moves can certainly help. For the longer term, though, the company absolutely must find a new product or technology to differentiate itself from the competition. Boston Scientific does not significantly under-spend in its R&D efforts, but the company must find ways to improve the yields from that work. The alternative is to continue to make expensive and/or risky acquisitions to refill the growth pipeline, and that is a strategy that has not worked all that well for Boston Scientific in the past.

The Bottom Line
Boston Scientific offers investors the mother of all Monte Carlo analyses. For instance, if Boston Scientific delivers historical free cash flow margins and future revenue growth of 2-3% (the general long-term consensus now), the stock is worth maybe $9 at best. If the company's operating efficiency drive works, however, and the company can match peer-group free cash flow production, the target jumps to $11.50. Likewise, if the company could find a new growth driver and boost its long-term revenue growth by one or two percent, investors could add another buck to the target.

The good news for investors is that current valuation on Boston Scientific seems to price in low single-digit cash flow growth in perpetuity. Even modest operating improvements, then, could lead to solid returns for patient investors. (For more, see Money To Be Made In Medical Devices.)

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