Where Do The Bears Go Next With St. Jude Medical?

In a sell-side world where Underperform/Sell ratings are pretty rare, is a bit of exception, as several analysts have either recommended that investors sell St. Jude Medical (NYSE:STJ) or have issued what I'd call "neutral … but we really mean sell" calls. Many of these analysts believe that St. Jude is going to see serious share loss in cardiac rhythm management (pacemakers and ICDs) due to safety problems with the leads, but that just hasn't happened. But with CRM revenue holding up, they're increasingly turning to worrying about earnings quality and long-term growth potential.

Although I think St. Jude shares have gotten a little expensive, I think the bears are going to have to work harder to make their case. Simply put, while St. Jude isn't even close to the most dynamic name in med-tech, it's doing better than the bears want to acknowledge. So although I expect another round of attempts to talk down the numbers/performance, I still see more opportunities for the company to do better in the coming years.

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Q2 Results Not Great, But More Than Good Enough
Much as the bears who believe St. Jude's problems with its leads should be leading to steep share loss won't like it, it's just not happening yet. In fact, St. Jude delivered a pretty decent set of results in a difficult market.

Revenue was down slightly as reported (less than 1%), but up about 2% in constant currency terms, good for a 3% beat relative to sell-side estimates. CRM revenue declined 2%, but that was 5% better than expected and St. Jude topped the high end of its own guidance range by about 3%. ICD revenue was flat, while pacing revenue was down 6%, but St. Jude showed the first quarter of growth in U.S. ICDs in about three years.

Elsewhere, the results were mediocre. Cardiology revenue growth of 3% was okay, and 12% growth in atrial fibrillation was better than expected, but not as good as Johnson & Johnson's (NYSE:JNJ) 16% growth for the quarter. Neuromodulation still remains pretty sluggish with just 2% growth. It's worth noting that while I call these results mediocre, every business was notably stronger (on a yoy growth basis) than in the first quarter.

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St. Jude likewise had mixed results in the margins – better than expected, but not great in absolute terms. Gross margin declined 110bp, but was slightly better than expected by the sell-side. Operating income declined 3% (1% better than expected), but operating margin declined about 80bp. I expect that bears will highlight the higher-than-expected spending in SG&A and try to make the case that the CRM growth was a byproduct of that SG&A spend (which may, or may not, be the case).

What Do Recent FDA Approvals Tell Us About The Lead Issue?
St. Jude does indeed have serious issues relating to old CRM leads, and the company is operating under FDA warning letters. Yet the FDA still approved the Ellipse ICD and Assura ICD in June (and they're manufactured at the facility covered by the warning letter). Both of these devices mitigate the risk of defective leads (they adjust the shock if there's a short in a lead and they have coatings that reduce lead friction) and that may be why the FDA approved them, but it's hard for me to reconcile the FDA giving the go-ahead to these products with the idea that St. Jude isn't making progress resolving its legacy lead issues.

What's The Future Worth?
We really won't know a lot about how St. Jude is faring in CRM under Boston Scientific (NYSE:BSX) reports earnings, but I expect that Medtronic (NYSE: MDT) will still be a share-gainer. My hope, though, is that the CRM business is growing again on an industry-wide basis.

That doesn't resolve some of the longer-term questions about St. Jude. On one hand, bears think that St. Jude is unlikely to make much impact against Edwards (NYSE:EW) and Medtronic in transcatheter heart valves (with its Portico valve), and likewise is going to be out-competed by Medtronic, Covidien (NYSE:COV), and maybe BSX and JNJ in renal denervation. I still maintain that St. Jude will do better than expected – not enough to lead any of these markets, but enough to offer upside to the long-term growth estimates.

Likewise, I think St. Jude is under-appreciated for the other growth opportunities it is accumulating. An investment in Spinal Modulation could give it access to a differentiated spinal cord stimulation platform, and I likewise think that CardioMEMS and a leadless pacemaker offer some long-term upside if they work out.

The Bottom Line
While I feel like I often come to St. Jude's defense, I'm not a huge bull on the stock today. With a long-term revenue growth rate of about 4% and a free cash flow growth rate slightly higher, St. Jude would seem to be worth about $45 after subtracting the company's net debt (which many analysts seem to ignore).

For the stock to be really interesting today (a fair value of $55 or higher), you have to go up to about 7% or 8% long-term cash flow growth and that seems a bit ambitious. Consequently, I think St. Jude is a respectable hold today, but not a particularly interesting destination for new money unless you believe that St. Jude will grow dramatically faster than its analysts believe, not to mention quite a bit faster than most of its larger med-tech peers.