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Why Boston Scientific Is Pumping Again

After a rocky patch following three recalls of its flagship product, the Taxus drug-coated coronary stent, Boston Scientific (BSX) seems to be getting back on track. In a midyear update on Sept. 1, the medical-device maker told analysts it has recaptured market share for Taxus and now expects revenue of $3 billion in the second half of 2004, including $1.3 billion in Taxus sales. The news came as a surprise to Wall Street, with investors pushing the stock up 5%, to $37.50, at the close of trading.

A closer look at the company's profit picture, however, shows signs of strain. Natick, (Mass.)-based Boston Scientific sees 2004 EPS between $1.60 and $1.65, below analysts' average expectation of $1.68. It also sees 2004 revenues between $5.49 billion and $5.58 billion, vs. Street estimates of $5.61 billion. And in August, Taxus sales slowed to $200 million, down from the $207 million reported in July.

BusinessWeek Online's Suzanne Robitaille corresponded by e-mail with Standard & Poor's equity analyst Robert Gold, who says he was surprised at Taxus' solid performance, given the product recalls, which came after malfunctioning stents were linked to 3 deaths and 47 injuries. Gold, who has a 3-STARS (hold) opinion on the stock, thinks recovering drug-coated stent sales, along with share buybacks, will drive earnings growth for the company in upcoming quarters. Here are edited excerpts of their conversation:

Q: Boston Scientific said sales and profit for the second half of the year will miss most analysts' estimates, yet its stock moved higher anyway. What gives?

A: We think investors are relieved that August Taxus sales only modestly trailed Wall Street expectations, despite the recent string of product recalls. The company's midpoint outlook wasn't dramatically different from the guidance it issued in February and was quite close to S&P forecasts regarding total sales, Taxus sales, and operating earnings.

We also think the stock is reacting favorably to the announcement that it will ask the board of directors to authorize a 70 million to 75 million share buyback. Finally, we see some short-covering [traders buying shares to close out short positions] built into the rally.

Q: The second-half revenue forecasts of $3 billion slightly beat your estimates. Were you surprised?

A: The guidance was ahead of our $2.8 billion estimate, but our forecasts assumed something of a worst-case scenario regarding Taxus sales interruptions. We're somewhat surprised that they were able to sustain momentum in Taxus, given the problems with balloon deflation and the associated recalls. But the drug-coated stent market is a duopoly, with Boston Scientific competing only against Johnson & Johnson (JNJ).

This market also continues to have more demand than supply, and we think Boston Scientific's ability to rebound so quickly was primarily a function of market dynamics. Cardiologists and hospital administrators simply don't have a wide range of choices in terms of drug-coated stent vendors, and we don't expect this scenario to change through 2006.

Q: Following the three Taxus recalls, the company says market share is back at 70%. Is the risk factor gone, or should investors still be cautious?

A: We don't anticipate any additional product recalls as it appears they've resolved their manufacturing problems to the satisfaction of both the Food & Drug Administration and physicians. However, the number of drug-coated stent implantations is large enough to assume that there may very well be more adverse patient events associated with the device, which isn't unusual with any new product launch that requires physician training and an associated learning curve.

Given the recalls, there could be more headline risk since the market remains extremely sensitive to the recent Taxus issues, and Boston Scientific has exhausted its goodwill with physicians and investors. Considering that these patients are already suffering from cardiovascular disease, however, this is a high-risk device category, and investors should recognize that this is the case with drug-coated stents and many other medical-device categories.

Q: Taking into account these risks and a likely falloff in stent demand, is a higher stock price sustainable over the next six months?

A: To the extent that our worse-case scenario doesn't unfold, we believe the stock will continue to gain some support. We're keeping our 3-STARS recommendation, which reflects a 12-month target price of $36. This target assumes that the stock can command a p-e of about 16 times our existing 2005 EPS forecast of $2.20.

We think the drug-coated stent market will begin to commoditize by mid-2005, with slowing unit-sales growth combined with reduced unit pricing. This would mirror the experience of bare-metal stents that were sold in the 90s. We think Boston Scientific will need to identify new growth drivers to command a multiple above 16 times the peak earnings growth we see in 2005.

Q: Has the company's profit update altered your opinion on J&J and its Cypher stent?

A: No. We've always expected Boston Scientific to emerge as the U.S. market leader due to the favorable characteristics evident with its stent-delivery system, particularly in more tortuous lesions in diabetic patients. J&J could resolve this by utilizing a similar stent-delivery system by Guidant (GDT), a company that presently co-markets Cypher. During 2005, we think the Taxus U.S. market share will slide towards 60%, and the overall growth rate of the market will ebb as a result of market saturation and price competition.

J&J recently launched Cypher in Japan, a market that could potentially rival Europe as the world's second largest. As the largest healthcare company in the world, however, J&J isn't as leveraged to drug-coated stents as Boston Scientific, so we feel J&J offers more defensive characteristics for investors who would prefer a more diversified name. We have a 5 STARS (buy) ranking and $58 price target on J&J.

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