Will Bad Leads Lead St. Jude Astray?

By Stephen D. Simpson, CFA | November 26, 2012 AAA

For a company that sold Wall Street on a pretty aggressive set of expectations, St. Jude Medical (NYSE:STJ) is certainly seeing the other side of the momentum trade. Worries about the company's pipeline and competitive positioning would be bad enough in their own right, but ongoing worries about the company's high-voltage leads threaten not only the company's valuation but also its competitive standing.

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The Lead Story Isn't Getting Any Better
Arguably the biggest challenge for St. Jude Medical today isn't the iffy state of the U.S. and European healthcare markets, but rather the company's ongoing issues with its high-voltage leads. To make a long story short, the company has had worrisome problems with the coatings that insulate the wires that connect an ICD device to the patient's heart. The company stopped selling an earlier lead (called Riata) in 2010, but has since run into problems with the newer Durata leads as well.

Questions about the Durata lead have culminated in St. Jude management warning investors that they expect to receive an FDA warning letter for the factory that makes the Durata leads. Recently, however, more details from an FDA 483 (a list of "observations" that precede a warning letter) highlighted concerns about the design history and validation process for the Durata leads.

At this point, it's anybody's guess as to what happens next. It doesn't sound as though the data so far will lead to a recall, but that possibility cannot be ruled out. In the meantime, it increasingly looks as though doctors are opting in some cases to switch to ICDs made by Medtronic (NYSE:MDT) or Boston Scientific (NYSE:BSX), or at least use different leads with St. Jude ICDs.

Were a full recall to materialize, the worst case scenario could see St. Jude lose perhaps half of its ICD market share (currently about 30%), and upwards of $1.00 per share in earnings. While it is clear that the company has a mess to clean up here, I don't currently believe the odds favor a recall. The more likely scenario (in my opinion) is that the company continues to gain share with its ICD "cans" (the devices themselves) while struggling to keep the lead business.

Last and not least, it's worth noting the relatively poor way in which management has handled this matter. St. Jude management has been pretty aggressive in criticizing physicians who've publicly questioned the safety of the Riata and Durata leads, and the initial company release of the FDA 483 was highly redacted.

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Is the Pipeline Losing Some Luster?
St. Jude's cardiac rhythm management (CRM) business is extremely important to the company, but CRM is seen by many as a no-to-low growth market for the future. Consequently, its St. Jude's pipeline has excited investors more recently, though this also creates some concerns.

The company's RESPECT trial was supposed to show that St. Jude's Amplatzer PFO Occluder delivers a clear benefit in reducing stroke. Unfortunately, the trial failed to meet its primary endpoint. While the data did show positive trends toward stroke reduction, it's now an open question as to whether the FDA will approve the device on the basis of this data and/or whether it will find significant clinical acceptance. The good news, such as it is, is that the device wasn't likely going to contribute much more than 2% to 2014 revenue, but here again management had been pretty aggressive and optimistic about the potential of the device.

St. Jude also recently announced that it had received a CE Mark (European approval) for its Portico transcatheter heart valve. I do believe that St. Jude's Portico is superior to Medtronic's CoreValve and Edwards Lifesciences' (NYSE:EW) Sapien, but both of these rivals have been on the market for a while and St. Jude faces an uphill battle - a battle complicated in the near term by a pretty adverse European reimbursement environment.

The Bottom Line
Despite these setbacks (in some cases, self-inflicted), I'm still bullish on St. Jude Medical. I have more faith than some sell-side analysts that St. Jude will maintain/build its CRM share, and that new products like Portico and the company's EnligHTN renal denervation system will compete effectively against the likes of Medtronic, Edwards, Covidien (NYSE:COV) and Boston Scientific. I'm also positive on other businesses like neuromodulation and ablation for atrial fibrillation.

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Part of what appeals to me about St. Jude shares is that a 5% free cash flow growth rate assumption is sufficient to drive a price target in the mid-$40s. I don't think that St. Jude can get there with CRM alone (which I do believe is a no-to-low growth business), but I believe that a little growth there supplemented by opportunities like transcatheter heart valves, atrial fibrillation and renal denervation should be enough. All of that said, there is a risk to the lead business (and by extension the ICD business) that cannot be ignored, and investors should not confuse St. Jude's attractive current price with a risk-free opportunity.

At the time of writing, Stephen D. Simpson did not own any shares in any company mentioned in this article.

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