Is This Fallen Angel Still a Good Growth Play?

Palwasha is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Healthcare stocks resemble tech stocks, in that both are eye candy to growth investors, show volatility over business cycles and thus have less appeal to value investors. Conclusively, it is important for growth investors to understand that if they pick high-growth companies with a strong market presence, they are likely to reap greater rewards during down markets than up markets. The reason is obvious. During down markets, the stronger companies will continue to grow (albeit slowly) while the weaker will be elbowed out. During up markets, even the smaller companies would show growth and rapidly catch up to the bigger ones, thus taking away a chunk of their revenues. 

This discussion is premised on Edwards Lifesciences' (NYSE: EW) present market position. As the US economy gradually expanded after the Great Recession, we saw a strong rally in Edwards. However, the momentum is now starting to break as competition is getting fiercer. Edwards Lifesciences is a medical device manufacturer and is known for its signature SAPIEN valves used to replace diseased aortic heart valves.

In spite of having a stronghold in the US, the company is starting to receive major setbacks in the European region. The company missed both earnings and revenue forecasts in the latest quarter and a selling frenzy, similar to the one seen back in October of last year, followed. The third quarter 2012 price slump, due to a revenue forecast miss, was the biggest Edwards had seen in a decade. Something similar was witnessed this past quarter, ended in April.  

<img alt="" src="" />

The bearish case

Medtronic (NYSE: MDT) is cited as Edwards' biggest competitor. Edwards managed to forestall Medtronic's entry into its primary market, the US. In the latest quarter alone, Edwards received over $84 million from the competitor in a patent litigation. While it may have contributed toward Edwards reporting a better EPS this quarter than what it could have been otherwise, Medtronic's Europe presence remains a huge threat to Edwards' future performance. Adding to Edwards' problems is the recent CE Mark approval of a valve-in-valve replacement technique using Medtronic's CoreValve--a direct substitute to Edwards' SAPIEN Valve. The approval is the first-of-its-kind in Europe.

Apart from Medtronic, St. Jude Medical (NYSE: STJ) is yet another device maker causing troubles for Edwards in Europe. St. Jude's Portico Valve received approval last year and gives EW holders another reason to worry about. And just when you think it can't get any worse, we hear of Boston Scientific's Lotus Valve System, which is currently awaiting approval in Europe, and once approved, may send shock waves across to all competitors. Edwards management was optimistic about its move to Japan last year but competition has also crept in there.

Additionally, the higher taxes on medical devices imposed by the Obama administration at the start of this year are yet another concern for the US manufacturers, with Edwards landing the top spot. 

<img alt="" src="" />

EW EPS Diluted Quarterly YoY Growth data by YCharts

In short, competition is starting to hamper revenue growth a little, however Edwards continues to deliver high EPS growth.

The bullish case

What's welcoming is that despite the forecast miss, Edwards managed to deliver 35.8% year-over-year growth in non-GAAP diluted earnings and 8.2% growth in revenues. The company still boasts the highest revenue growth, the highest return on assets and equity, the highest gross and net profit margins and the lowest debt-to-equity among all of its rivals. The only competitor closely following suit is Medtronic.

<img alt="" src="" />

EW Revenue Quarterly YoY Growth data by YCharts

Now, bear in mind that Medtronic is a dividend-paying stock with lower-than-average industry growth and low price multiples and holds a bigger presence in Europe, while Edwards is a non-dividend-paying stock that rewards shareholders with share repurchases, projects a higher-than-average industry growth with higher price multiples and has a bigger presence in the US market. Hence, comparing solely the performance of the two stocks (and not companies) wouldn't be fair, per se.

Bottom line 

A forward P/E of 21.44 and an analyst-estimated average EPS of $3.05 give Edwards a fair value of around $65, close to where it's trading now. Edwards may have the second-highest percentage of its float short, yet the short interest has decreased since the April slump, indicating its shift towards relative fair valuation.   

<table> <tbody> <tr> <td> </td> <td>Short Interest</td> <td>Change in Short Interest</td> </tr> <tr> <td><strong>EW</strong></td> <td> 3.55%</td> <td> -5.61%</td> </tr> <tr> <td><strong>MDT</strong></td> <td> 1.29%</td> <td> +16.78%</td> </tr> <tr> <td><strong>BSX</strong></td> <td>  2.82%</td> <td> +11.45%</td> </tr> <tr> <td><strong>STJ</strong></td> <td>  3.69%</td> <td> <p> +9.81% </p> </td> </tr> </tbody> </table>

The company's strength in the U.S., the clinical success of the improved SAPIEN XT Valve, the healthy revenue and earnings growth and the best fundamental metrics among competitors make it a buy. However, the mounting threat of competition in Europe, pressures to innovate in the wake of new and improved devices and techniques being constantly introduced in the market and taxation are reasons to be wary.

I have been bullish on Edwards for a year and still believe it's a growth story, but with the recent course of events, I recommend holding the horses just a little longer before going long or short on the stock.  

The Motley Fool's chief investment officer has selected his No. 1 stock for the next year. Find out which stock it is in the brand-new free report: "The Motley Fool's Top Stock for 2013." Just click here to access the report and find out the name of this under-the-radar company.

Palwasha Saaim has no position in any stocks mentioned. The Motley Fool owns shares of Medtronic. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

blog comments powered by Disqus