|By George S. Mack of The Life Sciences Report|
|Wednesday, 11 April 2012 04:52|
The Life Sciences Report: Back in early March you attended the 2012 Society of American Gastrointestinal and Endoscopic Surgeons (SAGES) meeting in San Diego. Were there topics or companies that the physicians were especially interested in?
Frederick Wise: Whether in a consumer setting or a medical meeting, doctors are drawn to what's new, just like consumers would be. Physicians want to see innovative technologies and understand them. There is a competitive element to it, and two of the biggest companies in the general surgery space were there: Covidien Ltd. (COV:NYSE ) and Johnson & Johnson (JNJ:NYSE) Ethicon Endo-Surgery. Both were displaying a number of new surgical products. I would say that one of the most exciting innovations right now in the medical technology space is in robotics, and for that reason there was a great deal of interest at SAGES in Intuitive Surgical Inc. (ISRG:NASDAQ), which is in the earliest stages of taking its da Vinci robot into the field of general surgery. That's a hot topic for sure.
TLSR: You follow the large-cap diversified supply and device companies. Every recession brings a shakeout that creates efficiencies in business. Have you seen this occur?
FW: That is a crucial point when thinking about this industry today. Virtually every large company I follow has, in some way, shape or form, announced formal restructurings, increases in efficiencies and headcount reduction. Many have combined business units and are looking for efficiencies in terms of manufacturing, distribution or sourcing among other factors.
TLSR: When the economy and employment recover and when patients return for the elective procedures they've been putting off, will these large companies be better positioned than they were in the past?
FW: Yes, I think the large-cap mature companies are moving past many of the obvious negatives and challenges, and are extremely well positioned to show some positive sales and operating leverage as the global economy gradually recovers. Most of these larger companies have market-leading positions in their major markets. All of them are reshaping their portfolios and focusing on more innovative, differentiated products and markets with potentially better pricing, better demand and better margins. We don't have to get back to 15% top-line growth to see leveraged bottom-line growth. Maybe we can get to a point in the recovery where incremental top-line growth of even 12% could produce very positive, very leveraged impacts on the bottom line.
TLSR: With a few exceptions you're basically in the large-cap medical device and diversified supply space. What case do you make for them?
FW: I've never been very fond of generalizing, but I think you have to start from the point that this group has underperformed the broader markets and often the rest of healthcare now for several years. Multiples are low; dividend yields have risen; free cash flow yields are actually at historically high levels. This is all understandable in the context of a maturing industry. I'm inclined to think that in a stable to improving economy, with procedures rebounding, tremendous cash flows, the improved operating leverage I mentioned, and with virtually all large-cap companies increasing dividend payouts, that these could be very attractive total return stories without a lot of risk over the next few years.
TLSR: Clearly, recurring revenue is part of the story for the mega-caps like Johnson & Johnson (J&J), Abbott Laboratories (ABT:NYSE) and even smaller large caps like Baxter International Inc. (BAX:NYSE) and Covidien. But these companies are so widely diversified in their product portfolios that growth is difficult. Also, huge market caps like $90 billion (B) are hard to double. What kind of edge can investors get?
FW: I don't know that there is an edge so to speak, but again, I don't think you have a lot of downside with the large-caps mega companies like J&J, with revenues approaching $70B, and Abbott, approaching $40B. My theme has been to focus on the relatively smaller large-cap companies. In particular, I'm thinking of St. Jude Medical Inc. (STJ:NYSE) and Stryker Corporation (SYK:NYSE) (now followed by another Leerink colleague), both of which have a relatively smaller revenue bases that should be growable, especially given their increasingly attractive portfolios—especially if the business has been run well and if their pipelines are growing and expanding. That happens to be the case with both of these companies.
TLSR: Speaking now to the mid-cap and small-cap companies in your coverage, is consolidation part of your theme?
FW: As I said, one of my themes is the low-risk, total-return concept. A second theme is buying the larger-cap companies with the best pipelines, but with a relatively small revenue basis and that are able to grow faster than the group average—like St. Jude Medical and Stryker. My last major theme is in the direction you suggest: consolidation.
TLSR: May we speak about some of your recommendations for investors? Let's talk about specific companies.
FW: I'm going to start with two companies I just initiated coverage on that I'm very excited about. These are at the opposite end of the spectrum from J&J, Abbott, Medtronic Inc. (MDT:NYSE), Boston Scientific Corp. (BSX:NYSE) and St. Jude.
First, I would like to mention AtriCure Inc. (ATRC:NASDAQ), the market leader in the surgical treatment of atrial fibrillation (AF), with roughly half of the surgical AF market.
TLSR: We're talking about atrial ablation, correct?
FW: Right, but ablation in a surgical setting. Atrial fibrillation, as you know, is a complex and very serious disease. The idea is that you burn lines in the heart tissue to stop the cascade of heart cell contractions, which is a harmful process that almost is like dominos falling, but in a chaotic fashion. With these burn lines, or lines of block, you prevent the electrical arrhythmias from running all over the heart, and if you are successful, you force them back into more regular patterns. Electrophysiologists do atrial ablation procedures as a catheter-based procedure from inside the heart. But, cardiac surgeons have a major opportunity to treat AF from outside the heart. And if you're doing coronary artery bypass graft (CABG) or valve replacement or repair procedures, with the chest open, you've got open access to treat the AF.
TLSR: What's the size of this market?
FW: In the U.S. alone, again just looking at the AF procedures done surgically, atrial ablation done with open-heart procedures could easily be a $250 million (M) market. In round numbers, there are about 350,000 (350K) CABGs done annually in the United States alone, and obviously a lot more internationally. Probably a quarter of them—or about 85K—are performed on patients who have AF, which is not surprising since older people, ages 60–80, tend to have multiple co-morbidities, multiple clinical issues. Of the 85K potential cases of AF, fewer than 20% of them are actually treated during a surgical procedure, despite the fact that it's very well documented in clinical studies that approximately 80–90% of these patients are cured if their AF is treated during surgery. Patients can even stop taking anticoagulants, which are expensive and produce complicating side effects that make it difficult for physicians to manage other co-morbidities. This is a great procedure.
TLSR: Rick, in December Atricure received FDA approval for an expanded AF indication for its Isolator Synergy Surgical Ablation system. You have written that this should drive growth, but the stock didn't react particularly favorably, or for that matter unfavorably.
FW: I'm glad you asked about that because it's important to reflect on the challenges AtriCure faces, as well as the opportunities. Historically, for a couple of reasons, the company was not able to optimally train and educate doctors about its atrial fibrillation treatment. Cardiac surgeons got excited about this approach to AF in the days before AtriCure became public in August 2005. Then the company faced a very challenging period from 2008 to 2010, when the Department of Justice (DOJ) and the U.S. Food and Drug Administration (FDA) stepped up enforcement on off-label promotion of medical products and drugs for all healthcare companies. Unfortunately, AtriCure was one of the first companies to feel the ramifications of this stepped-up enforcement. They weren't doing anything terrible, and their products were approved, but approved for general approaches to cardiac ablating procedures, rather than for specific targeted procedures, and not specifically for atrial fibrillation use. And so again the FDA decided to raise the bar, not just for AtriCure, but for everybody. We've also seen this same raising of the regulatory bar in the spine/orthopedic arm of the industry, for example. For Atricure, this process understandably changed the company's approach to training and education. The very good news for the company is that this DOJ investigation was fully resolved in 2010. Having been the first in, if you will, AtriCure is also now, in a sense, the first out. Now Atricure is the only company with an AF device specifically approved and labeled for educating and training doctors in atrial ablation, etc.
Having said all that, frankly, I can understand why investors are in a "show me" mode relative to the stock. Especially since I'm in that mode, too. But I believe the company is well positioned to show me—and show the rest of the investment community—that they have a real opportunity to drive surgical AF procedure penetration. It's like baking a cake in a way. If you have got all the ingredients—flour, sugar, butter, etc.—you can turn those ingredients into something very special. Although it will take a few quarters to see it show up in revenues, I think there's an above average chance that we'll see all the ingredients coming together to bake up something very tasty at AtriCure.
TLSR: Training is a major issue. It's important to get new modalities into teaching institutions because established clinicians do not want to take up new procedures. The cardiovascular surgeon wants to graft the new vessels onto the myocardium and get out.
FW: Well said and so true. As in the evolution of all procedures and all technologies, the docs are thinking about what they know from three, five or eight years ago, about earlier generations of these AF products and earlier experiences with less-evolved products and techniques. In the case of surgical atrial ablation, my due diligence suggests that under the best circumstances it can take only an additional five minutes of operating room time to do this procedure successfully. AtriCure's challenge is to bring that message more clearly, succinctly and directly to surgeons, and to help them understand what's possible despite their existing mindsets. This is trench warfare for Atricure—doctor by doctor, hospital by hospital. You can't just put an ad on the screen at the Super Bowl to make this process happen. It’s a doc-by-doc training and education process.
TLSR: What was the other company you just initiated coverage on?
FW: The other small-cap company is Unilife Corporation (UNIS:NASDAQ). It's more of a hospital supply-type name, but a very special one. Unilife manufactures prefilled syringes for large pharmaceutical and biotech companies that want to take both new pipeline products, as well as products coming off patent, and package them attractively in a user-friendly, safer way—and in the process meaningfully differentiate their delivery system from others. There's also the important and essential issue of preventing accidental needle sticks for health care workers and patients alike. The company has something like 12 issued patents on their safety and delivery technologies, with a core patent covering the key feature in all of Unilife's safety syringes, revolving around the method of needle retraction within an integrated device.
TLSR: Rick, because these are off-patent drugs and because only a device as been added, can these syringes be approved through the 510(k) process?
FW: The simple answer is yes, but your premise isn't 100% correct. Some are going to be drugs coming off patent, absolutely. But some are going to be drugs in development that can go through all the clinical trials with the Unilife device. Some devices will be approved as a 510(k), some will be approved as part of a device/drug combination.
TLSR: Unilife is a small-cap company, and manufacturing prefilled syringes sounds like a capital-intensive business. I'm curious to know about the drug trials you just referenced. Are the pharma partners going to be paying Unilife for these syringes during the trials? Is the company capitalized well enough to withstand these costs?
FW: Excellent question, because the company has barely any revenue right now. Unilife does have development/customization programs, and it does get paid, but the business is capital-intensive to the extent that it had to build a facility. You have to spend money on equipment to manufacture prototype devices, and the company has done this. Will it need additional capital going forward? The simple answer is probably yes. The complex answer is that maybe it will depend on how the deals are structured and how the cash flows are structured.
TLSR: What else are you talking to investors about currently, Rick?
Volcano has had an excellent track record since it became public in 2006. The company has steadily gained market share on a global basis and at the same time has invested heavily in the future. Right now the company has a global installed base of some 6,800 IVUS instruments alone in catheter labs around the world. And at this point, particularly with its latest generation platform, it has the opportunity to expand into other areas of imaging.
As I mentioned, right now both Volcano and St. Jude Medical are benefiting from the very rapid growth and acceptance of fractional flow reserve (FFR) technology, another important diagnostic tool for the catheter lab. It allows for very effective, very simple assessment of coronary artery blockages. Bottom line, right up front doctors get more accurate diagnoses and measurements to determine which patients should get a stent, and whether patients should be stented at all.
TLSR: Is Volcano an acquisition candidate?
FW: I definitely believe Volcano is an acquisition candidate. As a reminder, the other major player in the global IVUS market is Boston Scientific.
TLSR: Is Medtronic in this market?
FW: Medtronic does not offer either IVUS or FFR. Looking at the stent market, Abbott, Boston Scientific, and Medtronic are the three major players in the global stent market. But, of the three, only Boston has IVUS, not FFR, and again, Volcano has both an IVUS and an FFR offering, as well as a full pipeline of new additions to its precision guided therapy portfolio. So, you'd think that could be an interesting portfolio addition at some point.
TLSR: Do you also follow Boston Scientific?
FW: I think it's fair to say it is one of the most controversial large-cap stocks I follow. Boston Scientific has had a very difficult decade. The headwinds that the entire industry has been facing have been doubly or triply challenging for Boston Scientific for a host of reasons. The company very famously paid top dollar for Guidant in April 2006, just as the implantable cardioverter defibrillator (ICD) market slowed precipitously and just as the FDA was raising standards. Expenses were too high and revenues were slowing in a world that was changing dramatically, and the company suddenly found itself overleveraged. It has taken the company time to adapt to the changing environment and its changed circumstances—a process that is far along but still underway.
TLSR: You've got Boston Scientific rated Outperform. Why?
FW: Today, with an entirely new management team in place and with significant restructuring, the last of the major rating agencies has just returned the company's debt to investment grade from a junk rating. The company is generating over $1B/year free cash flow, and the business has now stabilized. It has made significant and important external investments in new and emerging markets, and in products. It very recently made an acquisition that brought with it some differentiated and potentially very exciting ICD technology. I think Boston has positioned itself for much better revenue and earnings-per-share growth over the next three to five years. Its stock has understandably been largely avoided, but over the next one to two years people are going to say, "Wow, that's better than I thought," as opposed to the opposite.
TLSR: You alluded to the recent (March) deal to acquire Cameron Health, which has developed a "leadless" ICD system. How important is a leadless system?
FW: This is a fascinating idea. Cameron has been working to develop this technology over the last decade, and Boston has been an investor from the beginning and has had an option to buy the company for a long time. There were very specific milestones, and Cameron must have met those milestones, based on the decision Boston has made to buy it.
For general background, you need to first appreciate that one of the major challenges in using ICDs is that the leads create many complications. Every major company has had performance challenges with their leads. Having thin wires inside a beating heart for years can take a toll on the products. With traditional ICDs, once the leads are in place they grow into the heart tissue, and it's hard to take them out without a very invasive procedure. If you could develop a product that, for a significant number of patients, could eliminate the need for a lead, the implantation procedure would be made simpler, faster, easier and less complicated. Cameron has done that. Boston has acquired them, and I think Boston could be well ahead of the pack in this respect.
TLSR: At minimum, then, you are thinking Boston Scientific's cardiac rhythm management division could be revived?
FW: A fully approved Cameron device would be transformative to Boston's cardiac rhythm management business. The ability to talk about a unique, and potentially game-changing, technology with hospitals and physicians would enhance Boston's ability to sustain and even gain both market share and physicians' mind share. All this could be quite positive for the company's Customer Relationship Management division outlook.
TLSR: Rick, many thanks to you. I've enjoyed this.
FW: Thank you. My pleasure.
Prior to joining Leerink Swann in 2008, Frederick "Rick" Wise was a senior managing director and medical supplies and devices analyst with Bear Stearns for 22 years. For the past 13 years, he has been a member of the Institutional Investor All-America Research Team, most recently with a runner-up ranking in the 2009 poll. He was also ranked #4 in the 2006, 2007, and 2008 Greenwich Associates U.S. Equity Analysts poll. Prior to joining Bear Stearns, Wise served as an analyst at Kidder, Peabody & Co. and at Forbes, Inc. Wise received a master's degree and a bachelor's degree from the Manhattan School of Music. He is also a Chartered Financial Analyst.
1) George S. Mack of The Life Sciences Report conducted this interview. He personally and/or his family own shares of the following companies mentioned in this interview: None.
2) The following companies mentioned in the interview are sponsors of The Life Sciences Report: None. Johnson & Johnson (JNJ:NYSE) is not affiliated with Streetwise Reports. Streetwise Reports does not accept stock in exchange for services.
3) Frederick Wise: I personally and/or my family own shares of the following companies mentioned in this interview: Abbott Laboratories (ABT:NYSE). I personally and/or my family am paid by the following companies mentioned in this interview: None. I was not paid by Streetwise Reports for participating in this story.
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